oversight

Acquisition of Major Weapons Systems

Published by the Government Accountability Office on 1971-04-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                            UNITED STATESGENIZRALACCOUNTINGOFFICE
                                   WASHINGTON,D.C.  20548

                                                                      FOR RELEASEON DELIVERY
                                                                      Fkpected at 1O:OO a,m. EDT
                                                                      April 29, 1971

                                  STATEMENTOF
              ELMERB. STAATS, COMPTROLLERGEMERALOF THE UMITED STATES
                                   BEFORETHE
                SUBCOMMITTEE                        IN GQmmNT
                           OM PRIORITIES AND ECONO!4Y             pf

     d                      JOINT ECONOKK COMMI!LTEE

\;       Mr. Chairman snd Members of the Committee:
               I am pleased to appear before this               Subcommittee today.         My

         statement deals primarily           with reports      we have recently      made
         concerning cacquisition of major weapons systems, the feasibility
                                                          7
         of making "should cost" reviews in auditing and pricing of
         negotiated      contracts,      a congressionally-directed          study of profits
         earned on defense contracts,               and a related     GAOinitiated    study of
d
         the return      on capital      of a selected     group of individual       contracts.
         This latter      study was designed to determine the feasibility                of allocat-
         ing capital      to individual      contracts      and to determine the range of return

         on capital      employed in individual          contracts,
              We have also included            attachments     updating work which we have
         done relative      to the Truth*in-Negotiations              Act (P.L. 87-653) and the
         use of Government-furnished            equipment by defense contractors.               Both

         have been subjects           of previous     hearings by this     Committee.
,
                                              0

                  We delivered               our second annual                     report      on major     weapon systems

         studies       on March 18, 1971.                    We concluded                   from our study        that     although

    \I   there have been substantial                             improvements               in the processes            followed

         by %he Department                   of Defense           in buying            major     weapon systems,            cost

         growth       is    still          a formidab2.e          problem.

                  We found           that     on 6n’ weapon systems where cowl.e%e                               cost     data      were

         available,           estimates           %o develop             and produce            the weapon systems            had in-

         creased       some $33.4 biEEion                   from         initial        estimates.           About one third             of

         this     increase,            or $9.5 billion                  represented            the difference           between       the

         estimates          prepared          when the           systems           were first       approved      for     development

         (the     planning           estimte)            and updated               esttiates      prepared       when the          systems

         were abmt            to be placed               under     a develiopment               contract,        The remaining

         $23.9 bilPion               imxease            was due to changes in quan%ities                          to be acquired

         and to a coua’bination                   of such things                   as engkneering           changes,      revisions

         to estimates,               and Frovisions               for     increased            co%% due to economic                inflation.

         The complete               digest      of mm March 18,197~~ report                            is attached         to this

         statement           (See Attaehnent               I) D

         Audit
         -..        of Program Estimates

                  I woukl           now like       to discuss             a question            you have raised           in the

         past     on the DOD cost                 estimates             contained           in the Selec%ed Acquisition

         Reports B that              is,     to what exkent               are the Selected                Acquisition        Reports

         audited,          certified          or verified           by the GAQ? Initially,                       I would like            to

         emphasize          that       our audit          is of the weapon system program,                              not the       Selec%ed

         Acquisition           Report         itself,            Our detailed               examination       is focused           on the da%a

         that      supports the sunmary infommtion                                    shown on the Selected &.quisition
         Report,


                                                                                                                                                 2
          The cost             information             shown on the Selected                      Acquisition           Reports      are

estimates              of projected             costs,         not costs           which     have actually             occurred.          I

believe          this     point         is often             misunderstood.                One cannot      apply         the same

verification              techniques             to estimates                as can be applied             to actual             costs.

For example,              the initial             planning           estimate         for      a new fighter             plane      often

starts          with     a planned             cost     figure       estimated             from a cost to weight                  relation-

ship derived               from earlier                fighters        that        are considered          to be r6ughl.y                equal.

There      are many assumptions                        implicit         in that       calculation.              We are able to

trace      planning             estimates back to supporting                               data    and attempt           to determine

that      all     pertinent             known factors               that      may affect           the estimates           are con-

sidered.               But the estimates                     are not precise;               cannot     really      be verified;

and usually              prove      to be overly                 optimistic.

          The next             estimate         shown on the Selected                       Acquisition         Report         is the

Government ’ s “development                            estimate        B”       These estimates               cannot      be

reconciled              with     the planning                 estimates,.           We can,        however,      compare them

to estimates               made by at least                    two contractorss                   As you. know, the contractor’s

estimates              are subject             to a review by the Defense                          Contract      Audit         Agency as

to the          currency,          completeness                and accuracy           of the contractor’s                  cost

data      supporting             his     price         proposals,              B    addition,         the contractor’s

technical.             proposal         5.~4given            an extensive           review        by various       Government

technical              personnel,

          In connection                 with     our continuing                 review of contract               pricing,           we

examine the work of these                              groups       and make intensive                  independent            examina-

tions      of these             data.          The factual           parts         we can,        and do verify.               Not all
of the assumptions                      inherent             in cost        projections           can be precisely               verified.

But we can determine                      whether             the   successful             contractor’s         final      price

proposal           is incorporated                    into     the Government’s                development         estimate.

                                                                                                                                                  3
                                             e                                                                 e
.       L




                   Finally,        each quarterly               Selected        Acquisition              Report         contains       an

        estimate          providing           as accurate           an indication                as possible             of current

        program        potential           costs.          In practice,          this         estimate          is the      develop-

        ment estimate              just     described,            adjusted       for         changes      in quantities;               for

        engineering            changes        required          to upgrade         a system performance                      or to correct

        system deficiencies;                   for      current      estimates               of the anticipated               effect          of

        economic         inflation;           for    estimating           errors        discovered              after     the develop-
    I
        ment estimate              has been established;                      and for         several          other     considerations.

        We can,        to some degree,               review        the bases           for     these      various         changes to

        the development               estimate.

                   For the future,             we are seeking                 to improve             the validity           of the data

        included         in the Selected              Acquisition              Report         with     respect          to potential           costs

        of major         weapon systems.                   We intend          to do this             through       our study         of the use

        of      “should~ost”              concepts         and through          the work of the Congressionally                                directed

        activity         of the Cost Accounting                     Standards           Board,         of which          I have been desig-

        nated       Chairman,         established              to promulgate            cost-accounting                  standards           designed

        for      use by prime             contractors           and subcontractors                    in the pricing,               administra-

        tion,       and settlement             of negotiated              defense            contracts          in excess          of $100,000.

        It      is my hope and belief                   that     we will        be successful,,

                   The identification                of need for              a weapon system and the relative

        priority         to be assigned              its       development         is a fundamental                     problem      in

        acquisition            of weapon systems.                   Initial        decisions             as to which          weapon

        system will           be developed              and the priority                of its         development           is made by

        any one of the military                      services,         but DOD has no organized                           method by

        which       such proposals             can be measured                 against         its     total       needs.




                                                                                                                                                          4
         Seemingly, the entire          structure         of the military      service     and the Office

of the Secretary         of Defense are involved              in this process,       in one way or
another,       and the long and imprecise               process of defining       and justifying           and

of redefining        and rejustifying              a weapon system, through many layers              of

involvement,        invariably       has delayed decisions             and has extended stated
availability        dates by years.
         The cumulative      effect     of the involvement             of many different       organiza-

tional     units    in the decision          to justify      and then to proceed with develop-
ment is the root cause of long delays in development decisions.                                 Almost
every weapon system we studied                     showed some substantial       degree of uncer-

tainty     as to whether,        when, or in what form the weapon should be developed.
         It occurs to us that ideally                 there should be a direct           relationship

between the missions for which weapon systems requirements                               are determined;
e.gy3 strategic         deterrent,      land tamfare,         ocean eorhwl,       etc,,     and the
organizational        structure       needed to acquire them.               The Office     of the
Secretary       of Defense has recently               implemented a new approach along these

lines.      Although still         in its      infancy     such an arrangement should facilitate

grouping related         weapon systems in packages of commonmission and would

permit putting        together       an acquisition         organization      of appropriate        size
and stature        to handle these matters,                Eventually,      we believe     program
management and organization                 will     evolve along mission lines.
Feasibility        of a Military       Price Index

         I would like     to touch on one other important                   point with respect to
cost estimating,         one in which you have expressed interest                    in the past.
I refer     to the problem of estimating                  the effect     of economic inflation            on

the cost of weapon systems.                  In testimony       before this     Committee on
May 20, 1970,                we told        you we planned                 to do additional                 work on this                problem.

Our review            is not yet            completed,            but we can make some observations                                     which

we think         will        be useful.

         As the first                step    in our work we reviewed                         all      of the studies                  we could

find     which        had been done by or for                        the Department                  of Defense              to develop

specialized             price        indexes       for     particular              weapon systems                  or components.                We

found     that        in no case had original                        research          been performed                      on the actual

cost     of such items.                  Rather,          average        hourly        earnings             and components               of the

Wholesale            Price      Index       available            from the Bureau of Labor                           Statistics             (BIS)

were combined                into     an index           for     the particular              military              item.        The selected

ccxnponent           indexes         were weighted               in proportion              to the portion                   of cost        to

which     each such index                   was judged            to pertain.               Since we could                   not find

that     any tests             had been performed                   to determine             the validity                   of this      method,

and since            in many cases the content                           of the selected                BLS indexes              appeared

to be quite             different           than    the content              of the military                  item          involved,        we

bad no basis             for        establishing               a level      of confidence               in these             indexes,

         In the next                phase of our work we conducted                             pilot         tests          in contractors’

plants       and in some cases we were able                                 to compute             indexes          reflecting             the

actual      price        movements           in those            contractors’              plants,           The indexes              we

developed            relate         to relatively               standard          items.       We are comparing                    the

movements            in the indexes             we developed                with      the general             price          movement

in the economy as indicated                              by the BLS indexes.                   . We are            still      analyzing

the results             of this         work.

         With regard                to non-standard                items     it     appears          that     it      would      require

very     difficllt             and costly          analysis          to separate              the effects                  of specification

change from price                    change for           a large          number of items.                   Our research                 suggests,
however,        that     where large               mounts       of unusual           material            and highly         specitiized

labor       such as titanium,                    and the labor          associated           in its        fabrication,              are

present        in a system,              the records          at contractors’                and vendors’             plants         would

allow       a determination               of the price           movements           in that         particular            portion         of

production.

          We have recently                discussed          the results           of our studies              with        & group

of consultants                who were given            draft     papers          containing             the results          of

the research            to which           I have referred.                The initial             consensus          of this

group       is that      it         would be wossible                  to compute an accurate                      price      index

for      military       hardware.                This group      suggested           that        estimates         of inflationary

effect        on costs         of military           items      should       start        with     the use of generally

available           indicators           such as the Wholesale                    Price      Index        or major         components

of that        index.          ‘Ike group          suggested       that      tests        such as we have conducted

should        continue         to be perfomed                to test       whether          or not in specific

instances           a really          significant           inequity       might      exist,

          We are encourged                by the fact           that      the BL9 is expanding                     the coverage

,of indexes          such as the Wholesale                    Price       Index      to include            items      more

representative                of the Aerospace               industry,            For example,             we are advised

that      executive           jet     aircraft       are being           incorporated             into     the Wholesale

Price       Index.       We are          still      evaluating           the u5e of improved                  BE3 indexes

tested       by work such as we have performed                              as a feasible                 alternative          to the

maintenance            of a fully           representative             military           pH,ce      index     containing             a
                                                                                                                     b
large       number of different                    series     of mi1~ta-q            items,
                    FEASIBILITY              OF USING "SHOULD COST" CONCEPTS


          In May 1969 this               Subcommittee             recommended that                     GAO study          the
                                                                             ',c
feasibility          of incorporating                  into     its     reviews         of contractor                performance

the tlshould         cost'"      method of estimating                      contractor            costs.           This     approach

attempts       to determine              the amount that                weapons systems                  or products

ought      to cost,         given      attainable             efficiency         and economy of operations

on the part          of contractors.                   In addition             to the traditional                   methods

of price       analysis,             using     historical             data,     these      reviews           incorporate

examinations           into      possible         improvements                in methods          of production

and other          areas      of potential             cost     reductions.

          In May 1970, we reported                      to the Congress                 that      it     appeared          to

be feasible          for      us to apply             "should         cosP      concepts          in our post-award

reviews       and that          we would        perform         a number of trial                      applications.              The

results       of our trial             reviews         at four         contractors'              plants          were reported

to the Congress               on February             26, 1971,            (See attachment                 II,     a digest

of this       report.1           We found         a number of areas                 at each of the plants

where we believe                action        could     have been taken               by the contractor                     to

lower      costs     to the Government.                       At one location              for         example,          a one-

time      investment          of about         $580,000          in an improved                production           control

system could           result         in annual         savings         estimated          at over           $3 million.

          Our review          also     identified             areas     where.Government                   contracting            or

administration              practices          adversely          affected        contract              costs.           For instance,

at one contractor's                   plant     the Government                was requiring                that      spare       parts

be packed for              indeterminate              storage         or overseas          shipment              although        the




                                                                                                                                         8
parts        were being        used for        overhaul          purposes         in the United           States.         In

this        case the potential              savings       could        range between              $200,000       and

$600,000          a year,      depending            on quantities           procured.

            The total         of the       savings       which    could          accrue      to the Government
                                                                  h'
as a result              of our reviews             at these      four      plants        could     not be readily

determined.               In those       instances,        however,          where we could             measure        the

effect         of suggested           improvements          in contractor              and Government            management

practices,              the annual       savings       amounted          to almost         $6 million.

            We brought        our findings            to the attention               of the procuring              agencies

and are monitoring                the actions            being      taken        to effect         savings.       We

were recently              advised,        in one instance,               that     our findings          would be

useful         in the negotiation              of the follow-on                  production         contracts,         and

that        many of the points              raised       during        our review          have already          been

included           in the initial           discussion          with      contractor          representatives.

            We are planning             additional        reviews.          However,          our statutory

authority              to examine       contractors'           records       is not broad            enough to cover

all        the matters       which       should       be considered.               In addition          to access        to

plant,         supervisory        and management personnel                        we should         have access         to:

       \--budgetary            information,

            --production         control       records,
       h
            --internal        studies,

            --profit       forecasts,

       "r -- management information                    systems,

            --labor       standards,        their      development           and application.
    Under our current              access-to-records                    authority          certain        of this         information

    would     usually       be available              as it      related       to a specific               contract,           but

    not on a plant             wide basis.

            Without        broader        authority           we will       have to depend on the voluntary

    cooperation         of contractors                for     access       to their         plants        and records.               In

    this    regard , along             with    our February               report     to the Congress                 we submitted

    proposed       draft       legislation            to your          Subcommittee           on Economy in Government.

    We also       submitted        this       draft         legislation        to the House and Senate

    Committees        on Armed Services                     and the House and Senate                      Committees           on

    Government        Operations.              We have had no indication                           to date        that     any

’   legislation         has been or will                    be introduced           on our proposal.

    Should Cost Efforts                 by Department              of Defense
    Components

            We believe          that      the greatest             benefits         will      accrue       TV the Government
                                                                                                                                           e
    when should         cost      concepts        are applied              by the      procurement               authorities          as

    part    of their        preaward          analysis          of contractor’s               proposals.             At that

    time,     the results          of should           cost      reviews       would        be of maximum effective-

    ness    in assisting           Government               negotiators        in arriving             at fair           and

    reasonable        prices.           Even more importantly,                      potential          Government

    contractors         will     be more likely                 to accept          should      cost       findings         and

    to implement           any needed corrective                       procedures          prior      to the award

    of a major        contract.

            One of the primary                 objectives              of GAO’s effort             will     therefore

    be to encourage             the military                services       to apply         should        cost     techniques
in their       preparation          for     negotiation          of selected         non-competitive                 type

procurements.             We plan         to examine      into         the reviews        performed         by the

military        services        to (1) determine           their         adequacy        and (2) evaluate

the responsiveness               of the contractors                   and the Government         to recommenda-

tions      of the review          teams.       Further,          it     is our intention         to periodically

analyze       all     of the findings           of the various             reviews        to determine

commonality           of deficiencies           and to develop             recommendations            for

corrective           action     to minimize       such problems              in future       contracts.

         At the present           time,      the Department              of the Army is utilizing

should       cost     review     techniques       to a greater             extent     than    the other

services.

         The Army has completed                four    reviews,           has three        underway,         and is

planning       ten more within              the next      year.         The Navy has completed

one review,           has one underway           and has no others                planned.       The Air         Force

has completed            one,    and has one additional                   planned     at this        time.

         We recently           completed      an evaluation              of the first        major     review

effort       by the Army and it              appears      that        the study      was adequately

conducted           by a very     capable      staff      and that         significant        savings         will

be realized.
                       METHODFOR DETEFMININGPROFIT OBJECTIVES
                             FOR NEGOTIATEDPROCUREMENT

          During the hearings          in November 1968 and in January 1969 the Sub-

committee on Economy in Government of this                       Committee developed in con-

siderable         detail     the need for a comprehensive study of profits                  realized

by defense contractors.               Subsequently,         the Armed Forces Appropriation

Authorization          Act for fiscal         year 1970, Public         Law 9i-121,     approved

November 19, 1969, directed                  GAO to study profits         earned on negotiated
contracts         and subcontracts       entered into by the Department of Defense,

National         Aeronautics      and Space Administration,             and the Coast Guard.

Contracts         of the Atomic Energy Commission awarded to meet requirements
of the .Department of Defense were also included.

          Witnesses in the hearings mentioned above expressed the view that

profit      objectives         for negotiated     contracts      should give greater        weight
to capital         investment.       The GAO, from an earlier             study for the House

Appropriations             Committee, and from other contract              audit work had also
developed some thoughts as to the need for consideration                              of invested
capital         in negotiating      defense contract         profits.      We therefore     decided
to make a concurrent              study to determine the feasibility              of relating
capital         employed to individual          contracts      and to ascertain        the range of
return      on capital       among individual       contracts,

          The procedures we followed             and our findings         are included     in our
report      dated March 17, 1971, and in attachments                     to 'this statement.        I

will      discuss here our recommendation.

          We believe        that of the various       ratios     available     for evaluating

profits         earned by contractors,          the percentage of profit          earned on total
capital         investment--     the total     investment      in all assets used in the
           '5
                                                                                                        $2
     business,       exclusive        of any Government-owned items or leased items--

‘\   is the most meaningful               for evaluating        defense profits.             The rate of

     return     on total       capital     investment     relates      earnings      to total         capital
     employed, regardless              of whether it was provided by the owners of a

     business,       its    creditors,      or its     suppliers.       Further,      interest         is not

     an allowable          cost under Government contracts               and must be paid out of

     profits,        The recurring         controversy      over this matter can be eliminated
     by considering           total    capital     in determining       profit     objectives.           By

     basing profits           on total     capital,     those contractors          that employ debt
     capital      will     have the funds to pay interest               and those that employ

     equity      capital      will    have the funds to pay dividends.
              In conducting our study we found that there was a great range in
     rates of return           on total     contractor      capital     committed to defense pro-
     duction.        This was true both for contractors1                  overall      annual rates of
     return      that we obtained          through use of a questionnaire,                   and for rates
     of return       for individual         contracts     that we reviewed,            We believe          that
     at least      part of the range in rate of return                   on defense work is due to
     the fact      that under current             defense contract       negotiation          procedures,
     little      consideration         is given to the amount of capital                    investment      re-

     quired from the contractor                  for contract       performance.           Instead,     profit
     objectives          are developed as a percentage of the anticipated                         costs of
     material,       labor,      and overhead.         As a result,      inequities          can and do

     arise      among contractors          providing     differing      proportions          of the capital

     required      for contract          performance where the risk,              complexity          and man-

     agement problems are similar.                    Also, by relating          profits      to costs,
contractors          in noncompetitive      situations            have little            incentive     to

make investments          in equipment which would increase                        efficiency.          Such

investments          tend to lower rather          than increase              profits      in the long
run.     Of course, other factors,               such as whether or not the program

involved      will     be continued,      could be an overriding                   consideration            in
bringing      about contractor         investments         to reduce costs.

        We believe       that it is essential             ix change the present system in

order to motivate           contractors     to reduce costs under Government non-

competitive          negotiated     contractss          Where the acquisition                of more effi-

cient    facilities       by contractors         will     result      in savings to the Govern-

ment in the form of lower contract                      costs,     contracturs            should be

encouraged e0 make such investments.                       Proper consideration                 of contrac-
tor provided capital              can cause a greater reliance                    on private         capital
to support defense production.                   To accomplish this,                    it is essential
that capital          investment      supersede or supplement, as conditions                           warrant,

estimated       costs as a basis for negotiating                    profit        rates.       We realize
that other factors           are also important,             such as life               expectancy of a
Government program and that contractors                          wi.lL not and should not invest

in facilities          simply because the investment                 will       be in the base upon
which profits          are figured.       Such investments             till       have to be economi-
cally    attractive        over the lives        of the assets involved.                     Most important,
however, the present strong incentive                      for contractors                to minimize their

investment       for Government work should be eliminated.

        In our opinion,           a system providing             for consideration             of capital
requirements          in negotiating      profit        rates would be fairer                 than the
     present       system to both contractors                and the Government.          It should help

     greatly       in identifying           situations      involving     a high rate of return              on
     capital       and will      provide information              to the contracting      officer       that

     we believe       now is available               in many cases to the contractor.
            Ue believe         also that the system adopted should be used krhere appli-
     cable by all        Government agencies since many contractors                       do work for
04
     more than one agency.
            In our March 17, 1971, report                    to the Congress we recommended that

     the Office       of Management and Budget take the lead in interagency                                devel-

     opment of uniform Government-wide guidelines                           for determining         profit
     objectives       for negotiating               Government contracts        -   guidelines       that will

     emphasize consideration                 of the total         amount of contractor       capital         re-
     quired where effective                 price     competition     is lacking.
     Procedures for Consideration                     of Invested     Capital

            We have not attempted to develop detailed                           changes in the Armed

     Services      Procurement           Regulation      (ASPR> required        for consideration            of
     invested      capital       in establishing          negotiated      defense contract        profit
     objectives.        However,          we have some thoughts           on this   and related        matters

     that   may be of         interest      to the Committee.

            The rate of return               on investment         in a business may be said to be

     made up of two major elements.
            (1)      A portion       relating         4x1return     on the actual     funds invested

                     in the business.
            (2)      A portion       t0 compensate for the business risks                  and degree

                     of management capability                required     due to the complexity
                     of the products produced.
          Where a business                       provides       all      of the capital              required          in contract

performance,               it     would be fairly                easy to establish                   a profit          objective

for      a particular               contract.              An overall              rate    of return         on investment

required           in contract              performance               could        be established            based upon con-

sideration               of the rate              of return           currently           being    realized           (1) by the

industry           involved,             and (2) by the specific                           company involved              on other

than      defense          sales.

          Where a portion                  of the capital                  is provided            by the Government

through       progress              payments          and/or          facilities            and equipment,             a more com-

plicated           situation             results.            In such cases where the Government                                capital

is relatively                   minor,      it     might       be desirable                to develop        an overall           profit

objective           based upon the total                        contractor                and Government             capital      re-

quired       and then reduce                      the profit           objective             to reflect        the interest

factor       on Government-furnished                            capital,              This     would       leave      a net profit

objective           representing                  a return       on the contractorsa                       capital       and a

return       for         the management               effort          involved,

          In cases where the Government                                  capital           contribution            is fairly        sub-

stantial,           it     would probably                   be desirable              to compute           separately          (1) a

rate      of return              on the contractors1                     financial            investment,            and (2) the

profit       or fee warranted                      based on the management                        effort       required.

          In contracts               such as for               operation            of Government-owned                  plants         and

for      services,              the capital           required           is furnished             by the Government                 to a

very      large          extent.          In these           cases the profit                  or fee has been and will

continue           to be based primarily                        on the management                   effort         required.
                                     l
1.   -.




                   Section 3-808 of ASPR and Chapter 12 of ASPRManual for Contract

          Pricing      set out guidelines          used by DODprocurement officials                    to develop

          profit      objectives      for negotiated         contracts      where analysis         of a con-

          tractor's      proposed costs is required.                   These sections       will     require

          revision      to reflect       consideration        of invested      capital.         We also believe

          that it      should be made clear in ASPR that where investment                            data is sub-

          mitted      by contractors       and used in pricing,             it comes under the certifica-

          tion requirement           established         for compliance with P.L. 87-653               (Truth-in-

          Negotiations       Act).
          Who Should Develop the System?

                   We believe       that the development of a system for considering                           con-
          tractor      invested      capital     in negotiating         Government contracts           is properly
          a responsibility           of the executive         branch of the Government.                Since sev-
          eral agencies are involved,                we recommended that the Office                 of Management

          and Budget take the lead in development of the system.
                   There are numerous articles               on the use of return           on investment         data

          and the concept is frequently                   used by industry          for such purposes as
          determining       whether to make plant investments,                      for pricing      contracts        or

          product lines,           and for evaluating         performance.           Further,      as discussed in
          our report,       a considerable          amount of work has been done by (1) NASA in
          developing       and testing         a contract     negotiation      procedure that provides

          for consideration           of contractor         invested     capital,      and (2) by DOD in

          developing       a somewhat different             system, but with the same objective.
          We think,      as a starting          point,     OMBshould evaluate           the work done to date
by NASA and DOD, proceed         with     any further         development      or testing     work

considered   necessary,      and prescribe         a system for          use by all     Government

agencies .   We do not believe          ‘the    problems      involved     are insurmountable.

      The procedures       we followed         in performing       our    studies     are described

in attachments    III     and IV to this         statement.
                            GOVERNMENT-OWNEDEQUIPMENT AND
                        RRAL FROPERTY FURNISRED TO CONTRACTORS

         Since hearings              on this          subject             before        the Subcommittee              on Economy

in Government              in November and December 1967,                                 the Department              of Defense

has taken        a number of actions                        designed           to improve          management          of its

property        in the possession                    of contractors,                     The Department           has adopted

a very       restrictive            policy      with             respect       to providing          additional

facilities         to contractors,                   but         there      has been little             actual        progress

in reducing             the amount of Government-owned                                  equipment       and real        property

in the custody              of contractors.

         The adequacy              of reimbursement                      to the Government              for     use of the

equipment         for      commercial          production                 continues         to be a problem.               We

are currently              examining          into         this      matter,           and other     aspects          of the

management of industrial                       plant             equipment           at 28 contractors’               plants.

Our preliminary                 observations           are that              there       continue       to be deficiencies

in contractors’                 records       of machine                 utilization         and a lack          of uniformity

in computing             rent      due for       commercial                 use of Government-owned                    equipment,

         Further         details       on this             subject          are included           in Attachment           V to

this     statement.

              PUBLIC LAW 87-653                  - ‘IRE TRUTH-IN-NEGOTIATIONS                            ACT

         We are continuing                   to devote             considerable             attention          to the audit

of contracts             negotiated          by the Department                         of,Defense.            Attachment         VI to

my statement             contains         information                on the work recently                     completed         and

reviews       underway,            as well       as our plans                  for      work in this           area    in the

immediate         future.

                                                           ***

         This completes              my formal              statement.
                                                                                                                                         19
                            0                                        0
.   I




                                                                            ATTACHMENT 1


    COMPTROLLERGENERAL'S                     ACQUISITION OF MAJOR WEAPONSYSTEMS
    REPORTTO THE CONGRESS                    Department    of Defense    B-163058


     DIGEST
    ------


    WHYTHE REVIEWWASMADE

         The large investment     required    in recent years for acquisition          of major
         weapons has impacted heavily        on the resources.available    for      other na-
         tional  goals and priorities.

         Acquiring    these major weapons involves         substantial   long-range     commitment
         of future    expenditures.       Because of deep concern in the Congress on these
         matters    and because of evidence that the weapon systems acquisition                pro-'
         cess has serious weaknesses, the General Accounting               Office   (GAO) has un-
         dertaken to provide the Congress and the Department of Defense (DOD)
         with a continuing       series of appraisals      of those factors      most closely   re-
         lated to effective       performance    in procuring    major weapons.      This report
         represents     GAO's first     such appraisal.


    FINDINGS AND CONCLVSIO;nlS
          1. Concurrent    with GAO's studies,        over the last several months the Of-
             fice of the Secretary       of Defense (OSD) and the ma'litary          services
             have been engaged in a substantial             effort to identify     and solve prob-
             lems that have adversely        affected     the acquisition     of major weapon
             systems in terms of compromised performance,               delayed availability,
             and increased     costs.    GAO has found that generally           the newer weapon
             procurements     are following     a slower development pace and procurement
             practices    are more conservative        than those of earlier       periods.   Be-
             cause many of the current         programs are in early states of acquisition,
             evidence of the results        of the changed'concepts         is not yet available
             to adequately     assess them, but the outlook is brighter.

          2. The identification      of need for a weapon system and the relative
             priority    to be assigned its development is a fundamental    problem            in
             acquisition      of weapon systems.

              Initial  decisions     as to which weapon system will be developed
              and the priority      of its development is made by any one of the mili-
              tary services,     but DOD has no organized method by which such pro-
              posals can be measured against its total       needs. Such a method is
              now under development but it is in its infancy.

          3. In recent months, the Office     of the Secretary          of Defense and the mil-
             itary  services   have paid extensive    attention       to the persistent   prob-
              lems of defining   performance  characteristics         of weapon systems and


                                                                                         71            *o

                                                 1
.       1




               of determining the technical feasibility             of achieving  that perfor-
               mance. There are many encouraging      signs         that these problems are
               being abated.

               Extensive    efforts      are being applied--early    in the weapon development
               process--to     identifying       areas with high design risks and to con-
               structing    and testing       the hardware itself  to demonstrate    the feasi-
               bility    of high-risk       components before proceeding   with further    devel-
               opment.

            4. In the preparation     of and attention given to cost--effectiveness
               determinations,    there was a wide range of quality.      This variation
               has lessened the value of these studies      to the entire     acquisition
               process.        +

            5. One of the most important        unresolved      problems in the management of
               major acquisitions       is the problem of organization.           The essence of
               the problem appears to be attempts           to combine the specialized        roles
               of major weapon systems acquisition           management into more or less
               traditional     military    command structures.        Because of this,    there
               usually     are a large number of organizations          not directly   involved
               which can only negatively        influence     the project.

               It occurs to GAO that ideally           there should be a direct      relationship
               between the missions for which weapon systems requirements                   are deter-
               mined; e.g.,    strategic    deterrent,       land warfare,  ocean control,       etc.,
               and the organizational       structure      needed to acquire them,       Such an
               arrangement would facilitate          grouping related weapon systems in pack-
               ages of common mission and would permit putting              together    an acquisi-
               tion organization       of appropriate      size and stature    to handle these
               matters.    Eventually,     GAO believes,        program management and organiza-
               tion will evolve along mission lines.

               There are other alternatives     involved,    but whichever     is chosen must
               clearly  provide for someone to be in charge? to nave authority           to
    I          make decisions   and to have full    responsibility      for the results.    The
               Deputy Secretary   of Defense has recognized        that the correction   of
               this problem is fundamental   to any real improvement and has stated
               that he plans to pursue it aggressively.

            6. GAO found that,       on 61 weapon systems where complete cost data were
               available,     estimates    to develop and produce the weapon system had
               increased     some $33.4 billion.       About one third of this increase,       or
               $9.5 billion,      represented    the difference   between the estimate    pre-
               pared when the system was first           approved for development    (the plan-
               ning estimate)       and an updated estimate .prepared when the system was
               about to be placed under a development contract.             The remaining
               $23.9 billion      increase was due to changes in quantities        to be acquired
               and to a combination        of such things as engineering     changes, revisions
               to estimates,      and provisions    for increased    cost due to economic in-
               flation.      (See p. 58.)



                                                  2
                                                                                                         21
RECOMMENDATIONS
             OR SUGGESTIONS
        The Secretary     of Defense    should:

        1. Make every effort   to develop and perfect    a Department-wide      method--
           now in its early stages of development--to      be followed by all mili-
           tary services   for determining  two things:    first,    what weapon systems
           are needed in relation    to the Department's   missions;     second, what
           the priority   of each should be in relation    to other systems and their
           missions.

        2. Establish   guidelines     and standards   for the preparation    and utiliza-
           tion of cost-effectiveness        studies.    These guidelines  should require
           that studies be updated and reviewed as part of the decision              process
           when major changes in cost and/or performance           require revised sched-
           ules for funding commitments.

        3. Place greater   decisionmaking       authority    for each major acquisition
           in a single organization      within     the service    concerned, with more
           direct  control  over the operations          of weapon systems programs and
           with sufficient   status to overcome organizational              conflict     between
           weapon system managers and the traditional            functional       organization.

        4. Ensure that each selected      acquisition     report     (a) contain a summary
           statement   regarding  the overall      acceptability      of the weapon for its
           mission,  (b) recognize   the relationships           of other weapon systems
           complementary    to the subject systems, and (c) reflect             the current
           status of program accomplishment.


AGENCYACTIONSAND UNRESOLVED
                          ISSUES

        DOD has been actively       pursuing a program to improve the management of
        the acquisition      of major weapons.       The Deputy Secretary  of Defense has
        assumed a significant       role in this improvement program.        It is too
        early to say how effective         many of these actions will be; but, if ef-
        fectively    pursued, they should result        in better management.     As GAO has
        noted previously,      beneficial    results   of some of these actions have be-
        come apparent.

        The comments by DOD on this report express only a general reaction   due
        to the limited  amount of time GAO was able to allow for DOD review.
        Because of the nature and importance  of this subject,  DOD wants to ex-
        amine the final  report further.


MATTEPSFOR CONSIDERATION
                       BY THE CONGRESS
        This report provides  the Congress with an independent  appraisal of the
        complex problems associated  with weapon systems development and procure-
        ment by DOD--a matter of serious concern in the Congress.

Tear Sheet
--
                                                                                                   22
                                                  3
.
                                  0                                          0    ATTACNMENT
                                                                                          II



                                                APPLICATION OF "SliOULD COST" CONCEPTS IN
                                                REVIEWS OF CONTRACTORS' OPERATIONS
                                                Department of Defense B-159896




        WHYTHE REVIEW PAS MADE
                            -
            In May 1969, the Subcommittee on Economy in Government,               Joint Economic
            Committee,       reporting    on "The Economics of Military     Procurement,"    ex-
            pressed concern that the traditional            method of 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 that     the General    Accounting    Office    (GAO)

                  “study the feasibiZity    of incorporating     into its audit
                  and review of contractor     performance    the should cost
                  method of estimating    contractor    costs on the basis of in-
                  dustrial  engineering   and financia2     management principles.”

            The should-cost    approach attempts to determine the amount that               weapons
            systems or products ought to cost, given attainable    efficiency               and econ-
            omy of operations.

            In May 1970, GAO reported    to the Congress that it appeared to be fea-
            sible to apply should-cost     concepts in its reviews.      GAO also stated
            that it would perform trial      reviews of this type to obtain additional
            information  concerning   benefits    that could be realized   and problems
            that might be encountered.

    c       This report    presents   GAO's findings    and conclusions      based on its     trial
            applications    of should-cost    concepts.
    h
    f
        FINDINGS AND CONCLUSIONS
            On the basis of four trial   reviews applying should-cost         techniques,   GAO
            has concluded that such reviews can be extremely       beneficial      and that it
            should make should-cost-type    reviews in the future,

            GAO found a number of areas        at each of four contractor   plants where in-
            creased management attention        could result  in lower costs to the Gover-
            ment.   For example,

              --improvements     were needed in production        planning   and control,

              --there     was a need for increased     competition     in the procurement       of
                 material    from subcontractors,     and
  --higher   quality engineering talent was utilized                 than was required        by
     the nature of the work being performed.

GAO brought the specific      findings   to the attention             of appropriate  con-
tractor  and agency officials       and made suggestions            for improvements.
(See pp. 8 to 10 and 14 to 15.)

Although should-cost       review techniques      primarily    are intended to find
out how contractors'       operations      can be improved, they also lead to dis-
closures  of areas where Govlernment contracting            or administration     prac-
tices affect    contract     costs adversely.      GAO noted instances       of exces-
sive packaging requirements,          failure   to consolidate    purchasing,    and ex-
cessive testing     requirements.         (See Pm 14 and 15.)

The total  savings which could accrue to the Government as a result         of
the GAO reviews and the resulting     improvements   in contractor    and Govern-
ment management practices     cannot be determined   readily   because the ef-
fects on costs of certain     of the suggestions   could not be measured
readily.   In those instances    where they could be determined,      the sav-
ings amounted to almost $6 million.       (See p. 33.)

The military     services      have performed should-cost         reviews in      order to be
in a better    position      to 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 its     reviews
should not be conducted in a preaward environment.

Future GAO reviews therefore       will attempt to evaluate hohi procuring        agen-
cies and contract   administrators      are discharging   thel'r responsibflities
and to suggest ways in which contractors         can reduce the ccsts to the
Government.    (See p* 21.)

Procuring    agencies that perform should-cost            reviews prior to the awards
of major contracts      are in a strategic       position     to obtain contractor          ,Zo-
operation    and concurrence     in changes needed,          Application     of should-cost
concepts during preaward reviews ena'sles Government contracting                     officers
to negotiate    from positions     of strength      because the comprehensive            find-
i‘ngs and observations      of the review teams are available             during negotia-
tions.    Since this type of information          is available,        the contracting
officer   can influence     the contractor     to adopt recommendations           for Sm-
proved operations.        (See p. 21.)

Although GAO had some success in encouraging         contractors     ta study and/
or improve their operations,     GAO could not be as effective          as the pro-
curing agencies in motivating     the contractors.        There was no obligation
on the part of contractors    to accept the suggestions         of the GAO review
teams, and in some instances     no interest    was shown in considering       GAO
proposals   objectively.   In other instances      contractors    took a positive
attitude  toward reducing th e costs of future       operations.       (See p. 22.)




                                                                                                   24
    The success of future    reviews of this type by GAO probably will         depend
    almost entirely  on the cooperation    of contractors       and on the extent to
    which the Department of Defense contracting       officials     apply GAO find-
    ings and recommendations     during negotiations    of contracts.      (See p. 22.)


AGENCYAND CONTRACTOR
                   COMMEIU'S

    The Office of the Assistant   Secretary  of Defense (Installations    and Lo-
    gistics)  advised GAO that the Department of Defense agencies concerned
    would look into the specific   matters  reported  by GAO at the contractors'
    plants.

    Pertinent    contractor     comments were:

      --GAO should place greater    emphasis on reviewing   overall         Government
         and contractor procurement   systems rather   than detailed         costs.

      --There should be some additional   evaluation     of cost benefits  result-
         ing from should-cost reviews versus'the     costs of accomplishment.

      --Additional      statutory   authority    for   GAO may not be necessary.

    GAO does place primary emphasis on evaluating           procurement     systems rather
    than detailed    costs,   and GAO reviews are so designed.          GAO also applies
    criteria   to ensure, insofar    as possible,    that the benefits       resulting
    from should-cost     reviews will be significant      in relation     to the costs
    of making the reviews.


M.4TTERSFOR CONSIDERATIONBY THE CONGRESS

    Should-cost     reviews require   examinations    into many facets    of contractors'
    operations     and management.    The present provisions     of GAO's statutory
    authority    to examine contractors'     records are not broad enough to en-
    able GAO to cover all of the matters         which should be considered.        The
    Congress therefore      may wish to consider     expanding GAO's statutory      au-
    thority    to enable GAO to make effective       should-cost   reviews on an in-
    dependent basis.




                                                                                             25
                                                                        ATTACHMElVIX-1




                                 PRocEDms USEDxx Trn
                                GENERALACCOUNTINGOFFICE
                                 IN DF-VEDOPING
                                              PROFITS OF
                                  DEFENSECONTRACTORS


Questionaire         Data
          We developed a questionnaire             to obtain annual information            from
selected       contractors      for the year, @1966 through 1969 on sales,                 profits,

total      capital     investment,     and contractor      equity    investment        for defense
business and comparable commercial sales.                       Provision    was made for

separate reporting            of the operating       results     for Government-owned
contractor-operated            (GOCO)facilities        and similar      activities       requiring
little      or no contractor         investment,     to prevent distortion           sf data on

return      on capital,

          Questionnaires       were sent to 154 contractors            which, as a group, had
received       (1) about 60 percent of recent DODprime contract                        awards of

$10,000 or more, (2) about 80 percent of similar                       NASA contract       awards, and

(3)      a significant       part of AEC' and Coast Guard contract             awards,      The lg4

contractors          in.cluded the 81 largest        DOD contractors,        excluding     oil

companies and nonprofit              companies, taken from a list            of the 100 con-

tractors       and their      subsidiaries    receiving        the largest    dollar     voluzne Of

military       prime contracts        of $10,000 or more in fiscal            year 1969.         Oil

companies were excluded because a major part of the procurement involved
had been a.dverti.sed                      or awarded through                  price     competition           and would

not have been affected                            by DOD’s policies               in negotiating              profit.

          In summarizing                   data     for     large       DOD contractors,              a large           corporation

was excluded               because          its     great      volume         of commercial           sales      would       have

substantially                   altered      our commercial                data    and the result              would       not have

been representative                        of most of the               companies        included       in the           study.

Also,      ,the defense              business             of 6 of the large              contractors           was primarily

in GOCO type               work which              we summarized              separately,            Thus,     our annual

profit         data       for      large      contractors              pertains        to 74 companies.

          We selected               63 additional              contractors             by taking       (1) every            72nd

contractor             from an alphabetical                     list       of DOD contractors                 receiving

awards of $10,000                    or more and totaling                      $500,000       or more in fiscal                   year

3.968, exclusive                  of the          81 top contractors               and their          subsidiary            companies

already         seLected,            and (2) some AEX contractors.                             Two of these               contractors

had gone out of business                            at the time            of our study,             so that       our results

for      the    smaller            contractors             are based on replies                for     61 contractors.

The 63. included                  47 smaller              defense       contractors          and 24 AEC contractors,

          We also          obtained          data         from IO contractors                who received               a major

part      of their              defense      business          in the form of subcontract                        awards.

          .A random selection                      of 40 of the            154 questionnaires                 was made for

verification               a-t the         contractors’             plants.        Each of the above groups                        was

represented               in the 40 questionnaires                         selected.          In addition,               each

remaining             questionnaire                was carefully              reviewed       and verified               through

calls,         letters,            and follow-up             visits        to the contractors’                 offices.            We

also      checked          to see whether                  the data provided                agreed     with      similar          data

in the         contraotors            ’ audited            financial          statements        and appeared              reasonable.
                                                                                                                                         3 r
                                                                                                                                         L” I
        In summarizing           the questionnaires             for   the 74 large           DOD contractors

we found     that    profi.t      on defense        work measured          as a percent         of sales

was significantly              lower    than    on comparable           commercial     work.       Due to

the effect      of Government-furnished                   capital,       we found     that     when profit

was considered        as a percent             of total      invested      capital,      the difference

narrowed     and when profit             was considered          as a percent         of equity      capital

there   was little         difference          between     the rate       of return      for    defense

work and that        for       commerci.al.     work.




                                                                                                               2%
                                                                        ATTACHMENT
                                                                                 IV


                               PROCEDURES USED INREVIEW
                                OF I~IVIDUAL CONTRACTS

       In reviewing         hearings of the Subcommittee on Economy in Government
on the subject        of the economics of military             procurement,        we noted
considerable       concern that return          on capital     had not been considered            in
negotiating       defense contract         prices.      For example, on page 16 of
published       hearings     for November 11 through 14, 11.968,Admiral Riekover

discussed       (1) two cases where a low percentage of profit                     based on costs
was very misleading           without     consideration      of the rate of return        on
capital,      and (2) that under the present              system of determining         profits

as a percentage of estimated               costs a contractor      who increases        his
efficiency      may in the long run lose profit,               since the latter        is deter-
mined as.-a percent of cost,,
       Later,     after     our review had started,          in hearings before the same
Subcommittee in May of 1970, Mr, Robert 3, Anthony, a former DOD

comptroller,       commented on the need for the computation of defense
profits,     as least       in part,. as a percentage of capital           employed.
       We also had developed some thoughts                 as to the need for consideration
of invested       capital     in negotiating         defense contract    profits      from work
we had done in examining into the use of the weighted guidelines                              for the
House Appropriations           Committee in 1967 and from other contract                 audit

work that we had done in the Department of Defense,
       As a result,         in addition     to the annual profit        data developed through

our questionnaire,           we decided to review a number of individual                 contracts
in order       to determine            whether      it         was generally         practicable           to develop

returnoninvestment                data by contract                 and to see whether                there      was a

great      range      in rates     of return             for     individual         contracts,         particularly

rates      of return        on capital

         We initially          considered          obtaining          a representative               sample of

recently       completed         defense      contracts,             however,        we soon abandoned

this      idea because         of the lack          of a readily               available         identification

of the universe             from which       a random sample could                        be selected.            We

planned      to base our study              on completed              contracts           in order      that      there

would      be no question          as to what the actual                       profits      were.

         The population           of Department                 of Defense        contracts         completed

during      any period         is unkown but might                   be constructed              by querying          every

contractor         that     had received           contract          awards.         About       180,000       contract

actions      of $10,000          or more are consummated                       each year by DOD.                However,

even if      the population             was limited              to contracts            over    $1 million        we

estimate       that       the number of such contract                         awards      amounts to about

5000 per year             and involve       over         800 contractors.

          One possible         approach      to obtaining               a viable          population         could      have

been to obtain             a listing       from     each of the 74 larger                       DOD contractors,

covered      in the        questisnnaire          phase of our study,                     of all     contracts

completed       during       the four       year         period      of our study,              regardless        of when

they     were awarded.            This     in itself             would have-been            a formidable             job

since      many of the         74 contractors                  were made up of numerous                 subsidiary

companies,            For excample , one contractor                     consisted          of more than           100

subsidiary         companies       as well         as nume’rous organizational                       contracting
points         belo~r      that       level.      that      would         ha:ve been -involved             in reporting

on completed               contracts.

          Once these               listings         were obtained              it    would      have been necessary

,to check a ntiber                    at the        site     to determine              whether      they     were accurate

and complete               prior       to inclusion                in a population              from which          selections

might      be made.               We have no real                  way of estimating              how many contracts

wo,uld be included                    in this         popu.lation.

          If     we could           have developed                 a population          it     would then          have been

necessary          to ,take a rand.om sax@e                           to determine             the final      sample       size

necessary          to produce                 statistics           that      would be of an acceptable                   level

of reliability,                     We decided             that     this      approach         would     not be feasible

and decided             to use a judgment                     sample instead.                  A judgment       sample

cannot         be objectively                  evaluated           by statistical              methods.       This      precludes

determination               of representativeness                          and any basis          for      measuring       and

quantitatively                expressing              the sampling             error      (precision)          and associated

degree          of confidence                 in the       sample estimates.                   From pilot       reviews      we

estimated          that       it      would take            an average              of 75 man-days          to develop

profit          and investment                 data      for a contract,                On the basis          of spending

about          10 to 3.3. thousand                man-days           on this        phase of the           study,     we

estimated           that      we could             cover      a maximum of about                 150 contracts,

Further,          to have the work done on a timely                                    basis     we pla-wed          on review-

ing      about      4 contracts                at each of the 40 locations.                             We actually        did

work at 37 contractors’                           plants          and these         were selected           based upon

consideration                of the following                     factors;

          (1)       Those with                the largest            volume         of DOD awards during               ~1.968.
           (2)      Products involved --we wanted to cover the major areas

                    where defense dollars             are being spent, such as, aircraft,
       g
                    missiles,     tank-automotive,         weapons, ammunition,              electronics,

                    communications equipment,

           (3) Availability           of qualified       personnel       and workload of our

                    regional    offices,
           We computed profit           as a percentage of sales and of costs for

eachcontract.               We also computed profit              as a percentage of the contrator's
capital          employed in contract             performance.       We excluded consideration                  of

Government-furnished               capital        and leased assets as we were interested
in the rate of return                 on resources provided by the contractor,                         Our
computation of -total capital                     employed included provision               for the cost
of work in process,               finished        goods, accounts receivable,               fixed    assets,
and other assets such as cash, raw materials,                             and prepaid expenses.
           The assets discussed above were financed                       on an overall        basis by
current          liabilities,      long-term        debt, and equity          capital.       We refer      to
this       overall       investment     in assets as total           capital      invested      (TCI),

In computing rate of return                      on TCI, we added interest               expense to net
profit,          since interest        represents      the return        to the providers           of debt

capital.

           After     determining       average contract          total    capital        investment,       we
computed the approximate                   contract     equity     capital     investment.          This
was done on the basis of the overall                       corporate         relationship       of equity
capital          to the total      liabilities        and capital.           The rate of return            on

equity       capital        was based on net contract              income before Federal income
.   1




        taxes     but after       deducting             all     contractor         expenses              allocable           to the

        contract,          indcluding       interest            expense,

                 The profit        rates     we computed                in our contract                  reviews          were substantially

        higher      than      the annual           profit       rates        developed          from our questionnaires,

        A comparison           of the rates             of return            on total          capital         investment         for    the

        37 companies           involved       showed 28 companies                       with     higher           rates      of return

        for     the individual            contracts            and 9 companies                 with      higher       rates     of return

        shown in their           questionnaires.                  A discrepancy                 was not unexpected                    since

        we had used. a judgment                    sample in our contract                       reviews           and it      would     have

        been pure          coincidence        if      the rates          had turned             out the           same.       We obtained

        numerous       explanations           for       the differences                 between          the      contract      and

        annual      profit      data of the 37 contractors.                              A few examples                   are as follows.

        1.      The contracts           we reviewed             for     one company were primarily                            related

                 to production             of missiles                and rockets.              These showed about

                 6 times       (34.2% versus                5.8% respectively)                  the      annual       rates     of

                 return       on TCI that           the       company reported                 in the questionnaire.

                 The lower       annual       rates           of return        were due to significant                         losses

                 in other       divisions            involving          shipyard         operations,               torpedo

                 production,        start          up costs           of a new ordnance                  plant,       and certain

                 f ixed-pri     ce development                 cant ract s *

        2.      The contracts           we reviewed             for     another         company were for                   missiles

                 and showed about             10 times           the rate         of return              on TCI of the

                 company as a whole                  (4% and 4.7% respectively)                            S While           the rates

                 of return        on contracts                were representative                     of the particular

                 company segment where they                           were     performed,              they       were not




                                                                                                                                               33
      representative       of the company as a whole.                 Two of the four

      contracts       involved     low investments           and high contract          profits

      due to the earning of incentives.                      Other segments of this
      corporation       were incurring       losses on a variety            of aircraft

      and ship construction            projects      for DOD, thus pulling              down the

      overall       average rate of return           on capital     for the entire           company,

3.   Contracts      we reviewed in the aerospace division                   of another

      corporation       showed about 3 times the rate of return                        on TCI of

      the company as a whole (28.24’0 and 10.2% respectively),                              Four of
      the five contracts           (3FPI   & IE'P)      earned about twice the average
      profit       on sales that T?as earned company wide.                  The rate of return

      on TCI was enhanced because the division                     that performed these
      contracts       held substantial       Government-furnished              equipment and was
      the only division           that received progress payments under its

      Government contracts,

4.    At another company, the contracts                  we reviewed were for an
      ammunition component, flares                 and aircraft     starting       cartridges,
      The overall       rate of return       on TCI for the contracts                  was about 5

      times the rate of return             on DOD sales for the company as a whole.

      (101,5$ and lp.%            respectively).         The contractor         is a sole
      source producer for the particular                     ammunition component and

      earned a high rate of profit                 on this     item as a result          of cost
      underruns,       and an above average going-in               profit      rate.      The contractor's
      investment       in fixed     assets was low because contractor-owned

      facilities       were about 60 percent depreciated.                   In addition,          the
      contractor       had substantial       Government-owned facilities                  used in
         performing          some of the contracts                   we reviewed,               The startir~

         cartridge          contract      that      we reviewed           earned      less       than     one-

         fourth      ,th.e rate        of return      on TCI that           was earned            on the

         ammunition          component          and f Pare contracts           ,      There were other

         producers          competing       for     the award of this               contract         and the going-

         in profit          rates      were lower.

5.      Contracts       covered         at another          contractor       were for            ammunition

         components 1           The rate          of return       on TCI for          the contracts               we

         examined. was over              four      ti.mes the rate          of return            on DOD business

         for      the corporati.on          as a whole           (115.276 and 27.0$               respectively             >.

         The manufacture               of the ammunition                 components          utilized        a sub-

         stantial       portion         of the Government-owned                    facilities            available

         and had a high             turnover        rate.        Other     products          furnished           to DOD

         included        development            and fabrication            of ground            handling         equip-

         ment for       missiles         and rockets            and cornmerci-al         type       proprietary

         items c       The latter         products          did not provide             as great           a rate      of

         return       and at least          in some instances               this      was caused by

         compett;ition         from other          suppliers.

         After       considering         the facts          developed       in checking             our data with

the contractors,               our auditors          did any additional                 review          work con-

sidered        necessary.

         As a result           of our contract              review       T@ork we found           that      there      was

a great        range     in profits.              For example,           the rate       of return           on

total     capital        investment         ranged      fTom a loss          of 78 percent                 to a profit

of 240 percent.                The range          in annual       rate     of return            on total         capital

obtained          through      our quest.ionnaire               was also      substantial.                 For example,
    for     Il.969 the rate     of return        range   for   the    74 large   DO13 contractors

    was from -X2 to -1-96, a range                of 108.      For all    4 years     the range     ir,

    rates     of return       on defense     work of the 74 contractors              was greater          on

    defense     work than       on commercial        work.      For example,        in 1969 the range

    on commerci.al.       work was from          -33 percent     to 439 percent,         a range    of
i
    72 compared with           108 for     the    saSne year    for    defense   work.
r   .




                                                                                                        *          ATTACHMENT V




                     c;WERNM.ENT-OWNEDPROPJZRTi F’UFU’KlXHEDTO CONTRACTORS
                                                                 ---

                 AS of June 30, 1970,                      the cost           of Department           of Defense-owned

        facilities           in contractors’                    custody       was $9.9 billion.                    This amount

        is substantially                the same as it                 was at June 30, 1967,                        The $9.9        billion

        is broken          down as follwos:                      industrial       plant          equipment          costing        over

        $L,OOO per           item--$2.2              billion;        other      plant      equipment-$2,4               billion,             of

        ,which $63 million                   is ADP equipment;                 and industri.al              real     property--

        $2,3 billion,                 There is no reported                     mount       for     special          tooling        and

        test     equipment.             It     has been estimated                  by DOD officials                  to be around

        $3 billion,

                  Since      the hearing s on Government                         procurement            and property               manage-

        ment before           the Stibcommittee                   on Economy in Government                         in Notimber            and

        December 1967,                the Department                of’ Defense         has taken           a number of actions
                                                                                                                                                             ’
        designed         to improve            its      management            of property          in the possession                    of

        contractors.                 Most of these               actions       can be directly               associa%ed            wikh
                                                                                                                                              . ..
        specific         recommendations                  of the Subcommittee.                     With      respeci       ,to fur-                    ’
                                                                                                                                ,
                                                                                                                                                                         I
        nishing         facilities            to contractors,                 DOD has restated               its     policy of - -*

        placing       maximum reliance                    on the use of privately                     owned production

        equipment          in connection                with      the performance                of defense          contracts,                        L

        Under Defense                Procurement            Circular          No, 63 dated          September           30, 1968,                      ”         _
                                                                                                                                                  ,
        the circumstances                    under which           Government-owned                facilities           will       be         ,       /; ’           ’

        furnished          to the contractor                     are very       limited.

                 With      respect           to improving            the management               of equipment           after

        it     has been placed                in the contractors’                  custody,         DOD’s principal

        actions       have been:
         1.     Recommendations to the Office      of Emergency Preparedness
                to revise lrental rates,    The rates were subsequently
                revised up&d      and are containedin    Defense Mobilization
                Order 8555’: l$dat ed June ~$8 ;

         2.     Tightening        up prior approval before                  Government-owned
                equipment        can be used on non-defense                  work.

Although        DOD has made some progress                  in its     efforts         to improve              the

management           of equipment         in the custody        of contractors,                 there        remain

a number of problems                 concerning      this     equipment.          Some of these                 relate

to:
         1.     Determination  of the adequacy                  of reimbursement   to the
                Government for utilization’of                   the property   by contractors
                for commercial production.

         2.     Identifying   equipment and facilities     for which current
                or future   needs are insufficient     to warrant  retention
                by the contractor.

         3.     Disposal        of equipment        and facilities           no longer               needed.

         In our November J-967 report                   on need for         improved           controls         over

Government-owned               property      in contractors’          plants          (B-1.40389)           we con-

cluded        that    the determination            of rent     on a machine-by-machine                         basis

would be more accurate                    and more equitable          than      the various             methods

in use.          In Povember 1568 we advised                  the Subcommittee                 that     DOD had

been conducting             a test        of 20 contractors’          plants          to study         the feasi-

bility        of maintaining          records      of equipment        utilization              on a machine-

by-machine           basis .      The test,       completed       in the latter               part     of

November 1968,             produced        such varied       cost    estimates          for     maintaining

utilization           records      that     the results       were considered                 inconclusive

as to whether           the cost          to maintain       such records         would be justified.

We were advised             by DOD offi’cials           at that      time      that     the adoption                 of



                                                                                                                          38
.   I




                                      0

        a, program        to phase-out          the use of Government-owned                              facilities             in the

        possession         of contractors                 was,     in their           opinion,      a more practical

        solution         to the problem             of contractors                using     Government-owned                    equip-

        ment for         purposes      other        than        authorized            in the contract,

                 In lieu         of requiring             utilization            records         on a machine-by-machine

        basis,         DOD revised         the Armed Services                    Procurement            Regulation         (ASPR)

        on June 30, 1969, to require                             contractors            to submit        in writing             their

        basis      for    determining          and allocating                  rental      charges.            Also,      ASPR

        was revised          to provide            for      establishing              a mi,nimu.m level            of utiliza-

        tion     for     industrial          equipment            so that        contracting            officers        can identify

        equipment         with     low usage for                which     retention          cannot        be justified.

        DOD Program          to Phase-Out                Facilities         in Possession               of Contractors

                 To emphasize          its     basic         policy       to place         maximum reliance                on the

        use of privately-owned                     facilities            in the performance                 of Government

        contracts,          DOD issued         a memorandum,                dated        March 4, 1970,               calling           for

        the phase-out             of Government-owned                    facilities             in the possession                of

        contractors          and subcontractors,                        Under the provisions                   of the memoran-

        dum each contractor,                  except         non-profit           contractors            and contractors

        operating         wholly      Government-owned                   plants         which     do not compete with

        commercial          firms,     would be required                    to submit            a plan which           would

        advise         the Department           of Defense              of its        intention         to replace         in-place

        Government-owned              facilities              in its      possession             with    privately         owned

        facilities.              Certain      types         of facilities               were exempted           and could             be

        retained         by contractors             when removal               to another           location          would be

        impractical          or too costly                in relation            to their         dollar       value.           All
,
1          other      equipment           was to be phased-out                  over     a period          not to exceed
pi
1
           5 years.           Any decis-ion             to continue       Government             ownership          of industrial

;+       ’ ?acil.ities          had to be justified                  to the Secretary               of Defense             as being

           in the best              interest          of the Government.

                     The military              services      and Defense              Supply     Agency first              reported

           to the Assistant                   Secretary       of Defense           (Installations            and Logistics)

           on the        status        of the phase-out              program          in December 1970.                   Out of
           821 phase-out               plan s expected,             111 plans          have been approved                  for     phasing-

           out Government               facilities          now in the possession                   of contractors.

                    We were told               that     some contractors               have not       submitted            plans

           because          their      production          contracts      with         the Government              will      terminate

           before        1973 which            is     the latest       date     for     implementation              of the phase-

           out plan.            Others         delayed      submitting          phase-out          plans     because             they
     L     favored          procuring          the Government-owned                   equipment      in their             possession

           but      there      is no legislation               permitting             the direct       sale of such produc-

            tion     equipment          through         negotiation         with       the holding          contractor.                  The

           Department               of Defense         has since       issued         a memorandum on February                          13,

            1971,     stating          that      the DOD was reassessing                   its     mobilization              produc-

            tion     planning          program.           The memorandum authorizes                    the Secretaries                    of

            the Departments               to approve          exemptions           or exceptions            to the basic

           policy        of the five             year     phase-out      plan.          We believe          that      this        memoran-

            dum will          suspend          some of the activity                which       ma,y have been anticipated

            in connection              with         the five-year       phase-out          plan,
    .
”




        GAO Reviews

                 Test equipment                that     should      have been provided                  by private              investment

                 Since our              statement       to     the Subcommittee              on Economy in Government

        in November 1968,                   concerning          Government-owned              property          furnished             to

        contractors,               we have continued               our surveillance                 of the DOD management

        of this          property.           Our most recent              report      on the subject                  pertained

        to an examination                   into      the controls          over     test     equipment              acq.uired        by

        contractors.                   On April       9, 1971,      we reported             (B-140389)           to the Congress

        that     significant               quantities          of plant      equipment--specifically,                           general

        purpose          test      equipment--have              been acquired           as special             test      equipment

        and paid          for      by the Government a We found                       that      five     contractors              had

        spent      for      the account             of the Government               an estimated           $12 million

        for     such equipment               which      should      have been provided                  by private              investment,

                 The acquisition                   of plant      equipment          as special          test         e&Pent            has

        been permitted                  by the Armed Services                Procurement             Regulation           definition

        of special              test     equipment       which      specifically             includes          all     components

        of any assemblies                   of such equipment.                This definition                  permits          the

        acquisition              of plant          eq.uipent      as special          test     equipment              when it         is

        to be included                  in a group       of test       equipment            items      assembled          for     a

        specific          use.

                 The Department                of Defense         concurred          in our recommendation                       to

        revise      the definition                  of special       test     equipment             to exclude          general-

        purpose          equipment          and said         the revision           would be made promptly,

                 Ineffective              management           of mobilization              reserve      equipment

                 In another              report       to the Congress              (B-140389,          dated April              7, lflO),

        we stated           that        ,there had been ineffective                   management,              by two Army
Commands, of industrial                      plant     equipment           retained       in mobilization

reserve        packages        to meet production                     contingencies         in time         of war.

These packages,              valued      at approximately                  $500 million,            contain          the

equipment         necessary         to produce           such items           as artillery,            rifles,

ammunition         casings,         and tanks.               Over a period            of years       the readi-

ness status             of that     equipment          had received            insufficient            attention.

Some equipment              packages         did not contain               enough equipment             to meet

planned        production         requirements;                others      had the capability                 for     more

production         than DOD estimated                  would be needed;                 while      others        were

being        retained       even ,though not identified                      with       a specific          producer

or plant.

         Our limited           tests     also        showed that,           during       one G-month period,

the possibility              existed         that     the Government             had spent          $6 million              to

buy new equipment--although                          similar          unneeded      equipment        was being

held     by the two Army commands and was not reported                                          as available            for

redistribution.

         As a result           of our report,                DO” is making            a study       of its          mobili-

zation        package       program      including             policies       and procedures            for         their

establishment,              justification,             approval,           retention,           and management.

The Army plans              to review         all     such packages              and report         to the Defense

Industrial          Plant      Equipment            Center      all     excess      production         equipment.

         Acquisition           of facilities             without          disclosure        to the Congress

         In January          1970 we also             reported           (B-140389)        that,     in a number

of cases,         the acquisition               of Government-owned                   contractor-operated

facilities         had been financed                  indirectly           through       the operating               con-

tractors,         and thus        had not been included                     in budget           requests         submitted
to ,the Congress.                    In t.hese cases we found                  that     the Departments                  of

the Navy and Air                 Force had authorized                  contractors             to provide           r”inanci.ng

for   facilities             costing        $31million              and to recover             costs      involved

through       overhead           charges         against          Government       contracts.             DOD has

assured       us that          its      internal       regulations          will       be revised              to (1)

preclude       indirect              financing       of industrial             real     property          and (2) to

ensure     that          acquisitiions           of such property              are disclosed              in budgeli

submissions              to the Congress.

GAO Follow-Up               Review in Progress

         As recommended in the April                              19% report          of this      Committee,             we

are currently               reviewing         the adequacy            of DOD’s controls                 over      the

acquisition              and utilization             o.? industrial            plant     equipment.               In this

conncetion,              we are looking            into      acquisitions             since     the September                 1968

instructions              contained         in Defense             Procurement         Circular         No. 63 restrict-

ing the furnishing                     of eauipment           to the contractors.                      We are also

examining          into      the need for            retention          of equi.pment           and the use of

equipment          for      commercial           purposes,          inc.Luding        the payment              of rent        for

such use.

         We are visiting                 a total       of 28 contractors                that      have in their

possession          plant            equipment     costing          about   $347 million,                 The amounts

of plant       equipment               at these      locations          range      between        $300,000         and

$55 03 million.

         Although          we do not expect                 to complete          our review            until      about

September          1971,       we have found               that     at the contractors             we visited                 there

has been very               little       acquisition              of Government-owned              equipment             in
the past         three        years.        [lowever,           there     continues           to be deficiencies

in contractors’                 records         of machi.ne utilization,                      and we are still.

finding        some cases where                  there        is a lack           of uniformity              in computing

rent      due for           commercial          use of Government-owned                       equipment.

          ALSO, in a number of instances                                we have found              Government            equip-

ment being            used on commercial                     work in excess            of 25 percent                of

available            time without           obtaining            prior      approval          from the Office                 of

Emergency            Preparedness           as required                by ,the Armed Services                   Procurement

Regulation.

ggislation             to Con”srol          Use of Government-Furnished
                                                                   --                               Equinment
                                                                                                         ”-
          S, 1469,           a biS1 to provide                 more effective               control          over       the use

of Government                production          eq.uipment            by private        contractors,               has been

%ntroduced            in the 92nd Congress.                       This bill          differs          in certain            impor-

tant      respects           from     similar      bills         introduced          previously.                With       limited

exceptions,            it     prohibits          furnishing             production          equipment           to all

contractors,                including       those           operating       Government-owned                  plants.

Current        DOD policy             as set forth              in ASPR 13-301,               concerning            furnishing

equipment            to contractors,              is consistent              with      this        prohibition,             except

for    furnishing             equipment          for        use in a Government-owned                        contractor-

operated         facility.

          It   appears          to us that,            if     the Government-owned                    contractor-operated

Concept        for     certain          types     of Defense             items      is’ to be retained,                    j.t will

be necessary                to continue          the authority              for     the Government                to     provide


facilities            and equipment              for        such plants.

          The previous              bills       provided         for     the negotiated               sale     of all         pro-

duction        equipment            at a fair          and reasonable               price      to the         holding
                  contractor.                  In commenting                on this      provision               in a previous       bill     the

                  Secretary             of Defense              gave his           support       to the proposed             legislation
             1.
          .,I‘j   adding         that     he felt              such legislation                would      facilitate         the phase-out
           “:i
I,z;;->
                  of Government-owned                          facilities           in the hands of contractors.

                            The legislative                     proposal       defines          production             equipment     and sets

                  it     apart      from        special-purpose                production              equipment,          special-purpose

                  production             systems,              and special           tooling          and special         test     equipment.

                  It     provides         for     the sale             of production                 equipment         by competitive

                  sale     and limits             negotiated                sale     to items          which       meet the definition

                  of special             purpose          production               equipment,          etc.        We believe       this

                  provi sion will,                 to a considerable                    degree,          diminish        the Government’s

                  opportunity             to divest               itself      of Government-owned                      equipment     by

                  delaying          the sale         of production                   equipment           until      the contracts           are

                  completed             or until          it      is determined               that     the equipment             is no longer

                  needed for             the purpose                intended         by the contractor.                    Under the pro-

                  visions         of the previous                     proposed        legislation,                negotiations       could        be

                  conducted             with     contractors                even though              the equipment          was currently
           ”
                  being      used in production                        under        Government           contracts.          We believe
            k$i
                  the Department’s                  plan          to divest          itself          of Government-owned             facilities

                  could      be accelerated                     by authorizing                sale by negotiation                 of all     equip-

                  ment to holding                  contractors.                    Although          the competitive             sale require-

                  ment of the present                          legislation           should          result       in greater       assurance

                  that      amounts            realized           from disposal               wiL1 be fair             and reasonable,            we

                  believe         that         the requirement                wilL      extend          the time        period     that     the

                  Department             will      be managing               large      inventories               of Government-owned

                  production             equipment,
          In addition,           S. 1469 would              also     (1) require            a periodic           review

of the circumstances                under which                 any production             equipment          was furnished

so that      the equipment               could     be removed as soon as the initial                                reason

for     providing       it     ceased to exist;                  and (2) prohibit                 the use of Covern-

ment equipment               on commercial              work.

         We agree       that      there      is need for             periodic         review         of the utiliza-

tion     of equipment            to determine             whether         its     retention          by the contractor

is appropriate.                On the other              hand,      some flexibility                might       be warranted

with     respect       to the commercial                  use of equipment.                   In this         connection,

we note       that     the position              of the Office             of Emergency              Preparedness

is that       such use may help                  keep the equipment                  in a high          state     of

oFerationa1           readiness          through         regular         usage,      may result             in substan-

tial      savings      to the Government,                   and may avoid             an inequity             to the

contractor           who is required              to retain          Government            equipment          in place

intermingled           with      contractor-owned                  equipment        required          for     commercial

work D

         We noted       that      the definition                 of production             equipment          excludes

special-purpose               production          equipment,             special-purpose              production

systems,       special         tooling       equipment,             and special            test      equipmentfor

commercial           purposes,           Also,     these         types     of equipment              are excluded

from periodic            reviews         to determine             whether         the circumstances               that

existed      prior       to furnishing             it     to the contractor                 still      exist.          If

it     is desired       to have the same restrictions                              apply      to special          produc-

tion     equipment,           special-purpose               production            systems,          special      tooling

eqtipment,           and special          test     equipment,             as well      as production              equip-

ment,      appropriate           changes         should         be made in the language                      of the bill.
                                                                                                AT!I!ACn#NT VI


                   ‘puBw[C LAW 87-653 - TH.E TRUTH-IN-NEGOTIATIONS                                        ACT

          As you know, the Law requires                          a contractor                 to submit          certified

cost      or pricing         data     for      use in negotiations                     of noncompetitive

contracts           expected      to exceed $100,000.                     It     also         provides          the

Government           a legal       right      to a price             adjustment          if     the price             had been

increased          because       of submission               of noncurrent,              incomplete              or inaccurate

cost      data.

          There      are several            basic       exceptj.ons       in the law to the requirement

for     submission         of cost          or pricing          data.          Brie is when the contracting

officer       determines           that      there         is adequate          price         competition;             a

second is when the price                       Ts based on a catalog                     price          of a commercial

item      sold      in substantial             quantities            to the general                  public;      a third

is when the head of the agency determines                                       that     the         requirements            for

certified           cost   data may be waived,

          In our      contract        audits         we cover         the basic          provisions              of the law

from the standpoint                 of their            effective        implementation                  by DOD.           We

review       selected        individual             eontracts         over      $lQQ,OOC whose prices                        were

established           on the basis             of certified             data.          We perform              broad       examina-

tions       into     contracting            officers’         determinations                  that     the      exceptions

exist       and certified           data       are not required

          In a statement            before          your     subcommittee              on December 29, 1969, we

discussed           our examination             of prices            negotiated          for         34 procurements

of general           purpose       bomb bodies              valued      at $343 miujon                   awarded           to six
.




    different          contractors.                 We reported          to xhe Congress                  on Per,wnber LtL!-?

    1969,       that

              --prices           for     33 procurements               of about         $309 miU.ion             were bigher

                 by about              $13.9     million      than      indi.cated        by cost          or pricing              data

                 available              to the      contractors          prior         to each negotiation,                   and

              --prices           for     12 procurements               of about         $172 million             included

                 cost      estimates             of about         $46 miLLion           for      which     sound and

                 realistic              cost     or pricing           data were not available.

    For each of the six                        contractors,           the negotiated              average        profit       ranged

    from ab0u.t 6.7 percent                        to Ill.4       percent        of negotiated             costs,         while

    actual       average          profits          ranged     from 6.4 percent                   to 30.2 percent              of

    actual       costs.

              Another           report         to the Congress           on July         15, 1969, describes                       our

    review       of prices              negotiated          under two contracts                   valued      at about             $23.3

    million        for     750-pound. bomb fuses.                       Negotiated            prices       included          estimated

    costs       that      were about $3.5 million                       higher         than      indicated         by cost          infor-

    mation       available              to the contractor               at the time              of negotiation.                   The

    contractor            had no factual                support        for     other     estimates           of about         $1.6

    million        consisting              of anticipated              price      increases,             production          lot

    losses,        scrap         and rework.               Since the         contract          was not completed                   at

    the time           of our review,               we did not compare the contractor’s                                   negotiated

    profit        of about             10 percent          with     the actual          profit         realized.           After

    our review,                the contractor              agreed      to a price             adjustment         of $1.3 million,

              I would           now like          to discuss          our audits          since        January      1970,          and

    our plans            for     the immediate              future.
    Contract     Prices          Based on Certified                Cost
@   or
    --  Pri  cingY&.

              We have i ssued. 16 reports                  to the Congress                cand. agency offi.cia1.s

    since      January      1, 1970,          covering       56 contracts               having    a value         of about

    $278 million           awarded to 34 contractors.                       Our findings                on overpricing

    totaled       about     $6 million.               Reviews      of contracts             awarded          13 other

    contractors           are underway.

              A sutmnasy report             will     be sent to the Congress                     on the work per-

    formed       each fiscal          year.          These summary reports,                  the first           of which

    will      cover     individual          reports       issued     during        fiscal        year        1.971, will

    provide       us with        a basis       for     identifying         and planning             broad        examinations

    into      selected.     areas         where improvements              appear to be needed.
                                                                             .I
              On December 29, 1970,                   we reported         to the Congress on the                     effec-

    tiveness          of revised          procedures       implementing          the Truth-In-Negotiations

    Act in achieving              fair      and reasonable           prices.             We also        reported.        on

    the problems           experienced             by contractors          and agency officials                     in

<   applying          the Act     and the impkmenting                 regulations.                We reviewed             35

    contracts,          valued       at $135 million            awarded to 21 contractors.                           The

    contracts          were primarily              awarded during          1968,          For ~8 procurements                  of

    $47 million,           the data         available        to the contractors                  at the time             of

    negotiation           indicated         that      negotiated      prices            should    have been $1.5

    million       lower I        Little       or no overpricing             was found            in the other             X7

    procurements           amounting          to about       $88 million,                The effectiveness                of

    the Act seems to depend. largely                         on how well           it     is administered                by

    Defense       procurement,             au.dit,     and technical           personnel.               It    seems too

    that      the cost      or pricing             data provisions          of the Act and the regula-

    tions      have posed no serious                   problems      for    Government             or industry.
     .
(i




                   A Defense          regulation             effective           January     1, 1970, established                     the

         requirement           for     prime         contractors             to obtain       and submit             cost     or pricj.ng

         data      in support          of major             prospective           subcontracts          to be awarded                on the

         basis       of cost         data,          Previously           there     was no specific                 regulation         requiring

         such a submission                   although          many contractors              did      so.     The prime          con-

         tractor’s         certification                   covers     the accuracy,            completeness,                and currency

         of the       subcontractor                 data,

                   Since    subcontract               cost      estimates          are a major             element         in contract

         prices,       we are currently                     planning         a review       to find         out if         (1) the new

         regulation         is being           effectively               implemented         by major         Defense         pro-

         curfzment      offices,             (2) subcontract                 estimates       are reasonable                 in rexa-

         tion      to available              cost     data,         and (3) improvements                   in this         area are

         needed,

                   Regarding          ,the provisions                in the law which               give     the Government

         a legal       right         to price         adjustments,               we reported          to the Congress                in

         1966 on the need for                       the Defense           Contract         Audit      Agency to establish

         a formal       program          for        conducting           postaward         audits      as a means of

         identifying           defective             pricing         data,        The Audit         Agency formally

         established           a program             for     regularly           scheduled         postaward          reviews        in

         March ~$6.             To aid the Audi-t Agency in this                               work,        Congress         enacted

         legislation           which         permits         the auditors             to examine            cost     records

         related       to firm          fixed-price             contracts.            The objectives                of the

         postaward         audits        are to identifid                 those      instances         where prices             were

         increased         because           data      submitted          were noncurrent,                 incomplete,          or

         inaccurate,           and to provide                  the contracting              officer         with     the facts

         needed to effect                price         reductions.
.




             By June 30, 1970,         the Audit Agency had performed postaward
    audits        on about 4,000 contracts          totaling      $38 biXli.on.        Defective

    pricing        of $185 million      on 787 contracts          was reported       to contrac-t-

    ing officials.          These officials         had completed actions            on 1.85 con-

    tracts        and had reduced contract          prices by about $14 million.

             We are currently         beginning     a review of the Defense Contract
    Audit Agency's defective              pricing    program.       We plan to determine the
    efficiency        and effectiveness        of the Audit Agency's performance,                   its
    basis for selecting          contracts        for review, the audit techniques
    employed, and the benefits              compared with the costs of the program.
    Exceptions        ,to Obtaining     Certified      Cost
    or Pricing        Data

             1,     Contract prices based on adequate
                    price competition
             'This year we started         a review of a number of negotiated                   pro-
    curements subjected          to the provisions             of Public Law 87-653 where the
    price was determined to have been based on adequate price competition.
                                                   3
    Defense regulations  establish criteria for identifying the presence of

    adequate price         competition,        We will     consider whether these standards are
    being correctly         and consistently         applied      and whether,       in practice,

    they provide        a sound basis for contract               pricing   without      requiring         sub-

    mission of certified             cost data.      We will.     also evaluate the application
    and effectiveness         of these standards to subcontract                   pricing.

             A provision     of the law requires           discussions       with all        offerors
    in a competitive         range, except where it              can be clearly        shown from
    the existence         of adequate competition              that acceptance of the ini-
    tial.    proposal withough discussion              would result        in a fair     and reason-
    able price        and offerors      are notified       in advance that award may be
.




    made witho.ut          discussions.              We will       review       the      circumstances                 under

    which      discussions         are conducted           with         competing         offerors             in order

    to understand           the objectives             7 the      substance,            and the            effect      of

    these      discussions         on contract           pricing,           We will           also         consider         the

    circumstances           and justification               for      awarding           contracts            without

    discussions.

              2.      Contract     prices       based on catalog                 prices

              Fublic      Law    BY-653provides             that        proposed         prices            may be accepted

    without         requiring       submission          of ce&fied               cost        data     if     they      are

    based on catalog              pr.‘tces     of commercial             items        sold     in substantial

    qumtities           to the public.               We examined            68 contracts              negotiated              on

    this      basis     and in December               1$9 we reported                 to the Congress                  on

    needed improvements              .

              For 45 of the          68 contracts,              there       was no record                  of the infor-

    mation         used to determine            that     substantial             quantities                had been sold

    to the public.               Defense       regulations           do not provide                  guidance          with

    respect         to the amount of commercial                      sales       that        should         be considered

    substantial.

              We found         instances       where the largest                 individual                cownercial.

    sale      of an item         at a catalog           price       was for       substantially                     smaller

    quantities          than     those       being     purchased         under        individual              Defense         con-

    tracts,           Under these          circumstances            there     was no assurance                       that     the

    price      paid by the Defense                   Department         would     have been paid by

    commercial          buyers      for      comparable         quantities.




                                                                                                                                     52
             We reco.mmended that,                   to improve            determinations               of t4nether          the

    catalog       price      exception           should      apply,         the Defense              Department

             1.    provide           more definite           criteria             for     determining           what con-

                   stitutes           substantial           sales         to the public;

             2.    require           appropriate          consideration                  of relative           quantities

                   involved           in individual           commercial                 sales      and sales       to the

                   Government ;

             3.    consider           requiring         the contracting                   officer      to      (a) obtain

                   a certi.ficat:‘.on             from the          contractor             that      the sales          data

                   submitted           are complete           and accurate,                     (b) include        a provi-

                   sion      in each proposal                and any resulting                      contract       which

                   would      permit        Government             representatives                  to examine the

                   contractor           ’ s pertinent         records             in order          to verify       the

                   information            suYbmitted         in support                 of the proposal,            and

                   (c> verify            sales       data    obtained             from contractors.

             The Defense             Department,          in September                  1970,     circulated        to industry

    associations           and Government               agencies           for         comment a proposed               revision        to
;
b   its     regulations         which         covered       most of our recommendations.                                The proposed
0
    changes       are still           under      consideration              by the Defense               Department.

             3.    Waivers of requirements                         for     certified
                   cost data

             public       I&W 87-653 authorizes                     the head of an agency to waive

    the requirement             for      certified          cost         data     in exceptional               cases,       pro-

    vided     he states         in miting             the reasons                for     such determination,                   Since

    enactment         of the law,           about       85 Secretarial                   waivers      have been issued

    by Defense          officials.             &lost of the waivers                      were considered            necessary

    because       the     item was urgently                 needed and the contractor                           was sole           source.
Some contractors               would     not provide        cost    or pricing         data   or a certificate,

or accept        a price         adjustment        clause    on the grounds            that   the     item      was

competitive            or that     its     price    was based       on an established               catalog      or

market    price ,         Waivers        have also     been granted           for     purchase       from

foreign       firms.        One waiver         has been made for          procurements           from        Canadian

contractors            under     special      arrangements         by which         the Canadian       Govern-

ment audits            the contracts          and obtains      a refund        for     the United           States

of any profits            over     10 percent        of estimated        costs.