oversight

Foreign Military Sales: DOD's Stabilized Rate Can Recover Full Cost

Published by the Government Accountability Office on 1997-09-18.

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

                  United States General Accounting Office

GAO               Report to the Honorable
                  Charles E. Grassley, U.S. Senate



September 1997
                  FOREIGN MILITARY
                  SALES
                  DOD’s Stabilized Rate
                  Can Recover Full Cost




GAO/AIMD-97-134
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Accounting and Information
      Management Division

      B-275670

      September 18, 1997

      The Honorable Charles E. Grassley
      United States Senate

      Dear Senator Grassley:

      This report responds to your request that we review the Department of
      Defense’s (DOD) use of stabilized rates for charging foreign military sales
      (FMS) customers for goods and services sold through DOD’s Defense
      Business Operations Fund (DBOF).1 You expressed concern that stabilized
      rates may not represent the full cost of the goods and services sold to FMS
      customers as required by the Arms Export Control Act of 1976. You
      specifically asked that we determine (1) if there is a dollar difference in
      pricing goods and services at full cost compared to the stabilized rate and,
      if so, (2) whether DOD’s current practice of billing foreign customers at the
      stabilized rate is consistent with the full cost requirements of the act.

      The Arms Export Control Act gives the President authority to sell defense
      articles and services to eligible foreign countries, generally at no cost to
      the U.S. government. While the Defense Security Assistance Agency (DSAA)
      has overall responsibility for administering the FMS program, the Army,
      Navy, and Air Force normally execute the sales agreements—commonly
      referred to as sales cases. As of September 30, 1996, there were over 90
      foreign countries participating in the FMS program, about 75 percent of
      which had been in the program for at least 10 years. During fiscal years
      1995 and 1996, annual DOD sales to FMS customers totaled about $10 billion,
      $2 billion of which were made by the Defense Working Capital Funds
      (WCF).2 Of the $2 billion in annual WCF sales, $1.5 billion or 75 percent were
      related to the sale of inventory items from Army, Navy, Air Force, and
      Defense Logistics Agency supply activities. Supply activities’ inventories
      consist of over 5 million different items ranging from food and clothing to
      new or rebuilt spare parts for various military weapon systems. The
      remaining $500 million of sales were made by the nonsupply WCF activities
      such as Army, Navy, and Air Force maintenance depots which perform



      1
       On December 11, 1996, the Under Secretary of Defense (Comptroller) reorganized DBOF and created
      four working capital funds: Army, Navy, Air Force, and Defense-wide. The four working capital funds
      will continue to operate under the revolving fund concept and charge customers the full cost of
      providing goods and services to them. Therefore, our findings and recommendations are applicable
      under the new working capital fund structure.
      2
       The other $8 billion of annual sales is generally for major weapons systems, such as aircraft and ships.
      These sales are made by non-WCF activities.



      Page 1                                                    GAO/AIMD-97-134 Foreign Military Sales
                   B-275670




                   maintenance and repair work on various weapon systems, including ships,
                   tanks, and aircraft.


                   DOD’s  stabilized rate generally is designed to recover full costs from DOD
Results in Brief   and FMS customers over the long term. The concept of applying the
                   stabilized rate is a viable method to recover the cost of goods and services
                   from these customers. Our analysis of cost elements in the stabilized rates
                   showed that generally, the stabilized rate included the cost elements
                   necessary to recover full cost. However, we did identify two cost
                   elements—pension and postretirement health benefits—related to
                   retirement benefit costs of civilian personnel working on FMS cases, that
                   were not included in the stabilized rates. We estimate that WCF supply
                   activities undercharged FMS customers at least $40.5 million during fiscal
                   years 1992 through 1996 and will undercharge millions more in fiscal year
                   1997. We discussed this matter with DOD officials and they agreed that not
                   all civilian retirement benefit labor costs were included in the rates that
                   activities were charging FMS customers. They now plan to revise their
                   policy to require that this cost be included in the prices charged FMS
                   customers.


                   Foreign military sales are made on a case by case basis. The cases are
Background         initiated by a foreign country sending a letter of request to DOD asking for
                   various information, such as precise price data. After the country obtains
                   and reviews this information and decides that it wants to do business with
                   the U.S. government, DOD prepares a Letter of Offer and Acceptance (LOA)
                   stating the terms of the sale for the goods and services being provided. If
                   accepted by the country, the LOA becomes the formal sales agreement by
                   which the U.S. government contracts with the country to sell it defense
                   articles or services.

                   Once the LOA is accepted, the foreign country is generally required to pay,
                   in advance, amounts necessary to cover costs associated with the sales
                   agreement. DOD then uses these funds, held in trust by the Department of
                   the Treasury, to pay private contractors and to reimburse DOD activities for
                   the cost of executing and administering the FMS agreement. As payments
                   are made, the military services report detailed disbursing and accounting
                   data to a central activity—the Defense Finance and Accounting Service,
                   Denver Center—which maintains the records of each country’s trust fund
                   balance and issues quarterly statements to foreign customers summarizing
                   amounts charged to their cases.



                   Page 2                                    GAO/AIMD-97-134 Foreign Military Sales
              B-275670




              In October 1991, DOD established DBOF, which consolidated into one
              revolving fund, nine existing industrial and stock funds that had operated
              within DOD for about 45 years, as well as the Defense Finance and
              Accounting Service, Defense Industrial Plant Equipment Service, Defense
              Commissary Agency, Defense Reutilization and Marketing Service, and
              Defense Technical Information Service. In establishing DBOF, one of DOD’s
              primary goals was to identify the total cost of operations and to highlight
              the cost implications of management decisions. DOD’s Financial
              Management Regulation 7000.14-R, Volumes 11B and 15 prescribe the
              financial management requirements, systems, and functions that WCF
              activities are to follow when establishing prices and billing FMS customers.3
              Generally, billings to these customers shall reimburse the WCF for the full
              cost incurred by the U.S. government for providing the goods or services.
              According to the regulation, full cost is determined by the application of
              the stabilized rates or unit prices which are set to achieve a break-even
              operating result in the budget year—that is, neither to make a profit nor
              incur a loss.

              Since the concept of DBOF was first put forth in February 1991, we have
              monitored and evaluated its implementation and operation. We have
              issued numerous reports discussing various problems with fragmented
              cost accounting systems and inaccurate financial reporting.4 More
              specifically, one problem we found was that not all costs were being
              captured in the price-setting process, thus, resulting in less than full cost
              recovery. However, in our May 1997 testimony before the Subcommittee
              on Defense, Senate Committee on Appropriations, we noted that DOD has
              progressed significantly in identifying the cost of doing business and
              including those costs in the prices DBOF charged its customers.5


              To determine regulatory requirements for billing FMS customers using
Scope and     stabilized rates and prices, we obtained and analyzed laws, policies,
Methodology   procedures, regulations, and guidance from DOD, Army, Navy, and Air
              Force officials. During our visits to DOD locations, we gathered and
              analyzed budget and accounting reports to identify cost elements in the
              prices of goods and services sold to FMS customers. We compared these

              3
               Financial Management Regulation, Volume 11B, Reimbursable Operations, Policy and
              Procedures—Defense Business Operations Fund and Financial Management Regulation, Volume 15,
              Security Assistance Policy and Procedures.
              4
               See Related GAO Products list in the back of this report.
              5
               Defense Depot Maintenance: Challenges Facing DOD in Managing Working Capital Funds
              (GAO/T-NSIAD/AIMD-97-152, May 7, 1997).



              Page 3                                                       GAO/AIMD-97-134 Foreign Military Sales
B-275670




cost elements with other cost data in various databases and met with
responsible agency officials to discuss and clarify any differences in
(1) cost elements used for FMS and DOD customers and (2) the amounts
charged.

To determine the amount of civilian pension and postretirement health
benefit costs that should have been collected from FMS customers by WCF
supply activities, we obtained and analyzed financial reports that showed
sales and expense data for Army, Navy, Air Force, and Defense Logistics
Agency supply activities for fiscal years 1992 through 1996. Because these
activities generally did not maintain data to identify how much time
personnel spent providing services to FMS customers, we estimated the
amounts of civilian pension and postretirement health benefit costs
related to FMS using certain assumptions. To do this, we first calculated the
dollar value of FMS sales as a percentage of total dollar sales for each of the
activities for each fiscal year. For example, if a supply activity showed that
its annual sales were $1 billion of which $100 million were to FMS
customers, we calculated sales to FMS customers to be 10 percent
($100 million divided by $1 billion).

To calculate the pension benefit costs, we multiplied the percent of each
year’s FMS sales by the total amount of civilian personnel salaries reported
as paid during the year to determine a pro rata dollar amount for FMS
civilian personnel salaries. Finally, to determine the estimated amount of
civilian pension benefit costs to be collected from FMS customers, we
multiplied the pro rata dollar amount of FMS personnel salaries times the
civilian pension benefit cost factor of 14.7 percent for each activity for
fiscal years 1992 through 1996.6 According to the Office of Management
and Budget (OMB) and DOD officials, the 14.7 percent rate represents the
“unfunded” portion of the pension benefit cost which is derived by
subtracting DOD’s 7 percent contribution to the pension costs of its
employees (21.7 percent less 7 percent). The 7 percent DOD contribution is
already included in the stabilized rate as a funded fringe benefit cost.

To determine the amount of civilian postretirement health benefit cost, we
multiplied the percentage of FMS sales to total sales times the civilian end




6
 The Office of Management and Budget provided DOD, based on Office of Personnel Management
data, composite percentage factors to use in calculating the government’s cost of civilian retirement
benefits. For fiscal years 1992 through 1996, the composite factor for the civil service and federal
employee retirement systems for the government’s portion of the pension benefit costs was
21.7 percent.



Page 4                                                    GAO/AIMD-97-134 Foreign Military Sales
B-275670




strength for each supply activity for fiscal years 1992 through 1996.7 For
example, if the pro rata amount of FMS sales to total sales was 10 percent
for fiscal year 1996 and an activity reported civilian end strength at 5,000
employees for the same period, our calculated FMS civilian end strength
would be 500 full time employees involved with FMS activities (10 percent
times 5,000 employees). Using these numbers, we multiplied the pro rata
amount by $2,166 which was the Office of Personnel Management (OPM)
calculated amount of average postretirement health benefit cost per
employee for fiscal year 1996.8 To determine the postretirement health
benefit cost per employee for fiscal year 1995 and earlier, we contacted
officials in OPM’s Office of Actuaries, including the Deputy Director of the
Office of Actuaries. According to the OPM officials, prior to fiscal year 1996,
OPM had not published any formal amounts for agencies to use in
calculating pension or postretirement health benefit costs. However, OPM
officials told us that postretirement health benefit costs have increased by
about 7 percent each fiscal year. Therefore, according to OPM officials, we
could determine the fiscal year 1995 postretirement health benefit cost by
dividing the fiscal year 1996 cost of $2,166 by 107 percent. Fiscal year 1994
could then be determined by dividing the fiscal year 1995 postretirement
health benefit cost by 107 percent and so on for each preceding fiscal year.
The OPM officials generally agreed with our methodologies for calculating
estimated pension and postretirement health benefit costs.

We did not calculate pension benefit cost for nonsupply activities because
the nonsupply activities were generally including these costs in their
prices for FMS customers. They did not, however, include the
postretirement health benefit cost in their prices. Since they were
recovering the largest segment of the retirement benefit cost, we did not
attempt to estimate undercharges for postretirement health benefit cost
for the nonsupply activities. To do so would have required us to analyze
numerous detailed accounting and budget reports of over 100 additional
WCF activities. Over the years, both we and the DOD Inspector General have
reported that the DOD’s financial systems used to collect and report data
are not capable of producing accurate and reliable information. Our
estimates were based on financial information provided by DOD which we
did not independently verify.


7
 Civilian personnel end strength (actual number of people employed at the end of the fiscal year) was
generally lower than full time equivalent personnel (average full time usage of authorized positions
during the fiscal year). We used the more conservative civilian end strength numbers for our
calculations.
8
 According to OPM’s Deputy Director of the Office of Actuaries, it was later determined that the $2,166
was overstated by about $55. However, at the time of our audit, OPM had not provided agencies with a
revised number for personnel costs. Therefore, we used $2,166 for our calculations.


Page 5                                                   GAO/AIMD-97-134 Foreign Military Sales
                           B-275670




                           We performed our work at the headquarters, Departments of the Army,
                           Navy, Air Force; Defense Security Assistance Agency; and Office of the
                           Under Secretary of Defense (Comptroller) in Washington, D.C. We also
                           performed audit work at the Army Materiel Command, Alexandria,
                           Virginia; Air Force Materiel Command, Wright Patterson Air Force Base,
                           Dayton, Ohio; Naval Inventory Control Point, Mechanicsburg,
                           Pennsylvania; Naval Air Warfare Center, Patuxent River, Maryland; Naval
                           Surface Warfare Center, Indian Head, Maryland; Defense Logistics Agency,
                           Fort Belvoir, Virginia; and Letterkenney Army Depot, Chambersburg,
                           Pennsylvania. We conducted our review from November 1996 through
                           July 1997 in accordance with generally accepted government auditing
                           standards.

                           We requested written comments on a draft of the report from the
                           Secretary of Defense or his designee. The Acting Under Secretary of
                           Defense (Comptroller) provided written comments, which are discussed in
                           the “Agency Comments” section and reprinted in appendix I.


                           The concept of a stabilized rate is a viable method to use for pricing goods
Stabilized Rates           and services sold to FMS customers. If this rate is applied consistently and
Should Allow               contains all known cost elements, it should recover the full cost of
Recovery of Costs          operations over the long term. In analyzing the cost elements in the
                           stabilized rate, we identified additional elements—pension and
Over the Long Term         postretirement health benefit costs which are part of the civilian labor
                           costs—that should have been included in developing the stabilized rate
                           and charged to FMS customers. Omission of these costs resulted in
                           estimated underbillings of more than $40.5 million since fiscal year 1992.


Stabilized Price-Setting   Present DOD policy requires the WCF activities to establish prices that allow
Process                    them to recover from their customers the expected costs, including any
                           prior years’ losses. WCF activities are to establish prices prior to the start of
                           each fiscal year and apply these predetermined (stabilized or standard)
                           prices to most orders and requisitions received during the year. Because
                           sales prices are based on expected costs and workload,
                           higher-than-expected costs or lower-than-expected customer demand for
                           goods and services can cause the WCF activities to incur losses.
                           Conversely, lower-than-expected costs or higher-than-expected customer
                           demand for goods and services can result in profits.




                           Page 6                                       GAO/AIMD-97-134 Foreign Military Sales
                                B-275670




                                The process for establishing stabilized prices for WCFs generally begins
                                about 2 years before the prices go into effect, with managers from each
                                WCF developing workload projections for the budget year. After WCF
                                managers estimate their workloads based on customer input, they (1) use
                                productivity projections to estimate how many people they will need to
                                accomplish the work, (2) prepare a budget that identifies the labor,
                                material, and other expected costs, and (3) develop prices that, when
                                applied to the projected workload, should allow them to recover operating
                                costs from their customers. Not all cost elements are applicable to all WCF
                                activities. For example, the cost element of inventory losses/obsolescence
                                generally applies only to WCF supply activities that maintain inventories.
                                Below is a list of major cost elements used to develop stabilized rates:

                            •   direct and indirect labor,
                            •   direct material,
                            •   general and administrative expenses,
                            •   inventory losses/obsolescence,
                            •   inventory maintenance,
                            •   condemnation of inventory items,
                            •   inflation,
                            •   accumulated operating results gains or losses,
                            •   depreciation, and
                            •   joint logistics systems center (JLSC) surcharge.

                                Major commands responsible for the overall management of the WCFs
                                review the budget estimates and consolidate individual business area
                                activities’ budget estimates. The military services’ and DOD components’
                                headquarters and the Office of the Secretary of Defense also review the
                                budget estimates before they are submitted to the Congress as part of the
                                annual budget. Any changes made during the DOD budget review process
                                are incorporated into the WCFs’ prices before the beginning of the fiscal
                                year. With the exception of retirement benefit costs for civilian employees,
                                which is discussed below, we found that all of the key cost elements to
                                recover full cost from FMS customers are now included in the stabilized
                                price.


Civilian Pension and            The costs not charged by the WCF supply activities, which were responsible
Postretirement Health           for about $1.5 billion (75 percent) of the WCFs annual sales to FMS
Benefit Costs Were Not          customers, consisted of a portion of the government’s share of the full cost
                                for pension and postretirement health benefit costs for civilian personnel
Included in Supply Prices       who worked on FMS cases. The employee and the employing agency both



                                Page 7                                    GAO/AIMD-97-134 Foreign Military Sales
B-275670




contribute annually toward the cost of the future pension benefits. While
the contributions made by DOD are now part of the stabilized rate, the
employee and agency contributions are less than the full cost of providing
the pension benefits. Therefore, the federal government must, in effect,
make up the funding shortfall. In addition, neither the agency nor the
employee pays the federal government’s portion of postretirement health
benefit costs. Both the pension and postretirement health benefit costs
will eventually be paid out of the general funds in the Treasury—not by
DOD. Since the pension and postretirement health benefits are costs to the
government, they should be added to the stabilized rate and recovered
from FMS customers.9 In this regard, we found that the nonsupply activities
we visited recognized this and modified the stabilized rate to include the
full pension costs in the prices they charged FMS customers. However, they
did not include the postretirement health benefit cost. As noted earlier, we
did not attempt to estimate the postretirement health benefit cost for
nonsupply activities.

Including retirement benefit costs is consistent with the Statement of
Federal Financial Accounting Standards Number 4, which states that
federal agencies should measure and report direct and indirect costs that
contribute to output, regardless of funding sources. It is also consistent
with OMB Circular No. A-25, which established the guidelines for federal
agencies to assess fees for government services. The guidance notes that
user charges will be sufficient to recover the full cost to the federal
government of providing the service, resource, or goods. The circular
points out that “full cost” is to include all direct and indirect costs to any
part of the federal government of providing a good, resource, or service.
Under the circular, these costs include, but are not limited to, an
appropriate share of direct and indirect personnel costs, such as accrued
retirement cost not covered by employee contributions.

Because WCF supply activities did not maintain data to identify the time
personnel spent providing services to FMS customers, our estimates for
civilian pension and postretirement health benefit costs were calculated
based on assumptions discussed in our scope and methodology. Table 1
shows the results of our calculations for each of the WCF supply activities
for fiscal years 1992 through 1996.




9
 DOD policy requires WCF activities to return collections of these costs to the Department of the
Treasury.



Page 8                                                   GAO/AIMD-97-134 Foreign Military Sales
                                     B-275670




Table 1: Estimated Undercharges
Related to Civilian Pension and      Dollars in millions
Postretirement Health Benefits for                                                  Postretirement
Fiscal Years 1992 Through 1996                                  Pension benefit      health benefit       Total benefit
                                     WCF supply activity         undercharges        undercharges        undercharges
                                     Defense Logistics Agency            $ 12.4                $ 5.5              $ 17.9
                                     Navy                                   6.2                 2.2                  8.4
                                     Army                                   5.5                 1.7                  7.2
                                     Air Force                              5.3                 1.7                  7.0
                                     Total                               $ 29.4              $ 11.1               $ 40.5

                                     In discussing this matter with DOD Comptroller officials, they
                                     acknowledged that civilian retirement benefits were a cost to the
                                     government which should be included in the stabilized rate and charged to
                                     FMS customers. They told us they are planning to revise their policy so that
                                     this cost will be included in the prices charged FMS customers beginning
                                     no later than fiscal year 1998.

                                     With regard to the $40.5 million of undercharges shown in table 1 and any
                                     additional undercharges that were made during fiscal year 1997, DOD policy
                                     requires that all proper charges be recorded against the applicable FMS
                                     case. According to the policy, case closure does not stop the billing
                                     process. Further, the standard FMS sales contract provides that the FMS
                                     customer is to pay the U. S. government the total cost of the items even if
                                     that cost exceeds the amounts estimated in the LOA. Also, we have issued
                                     numerous reports over the years that have (1) identified tens of millions of
                                     dollars of undercharges related to the costs for goods and services
                                     provided to FMS customers and (2) recommended that DOD retroactively
                                     collect the underbillings. Generally, DOD agreed with our earlier findings
                                     and recommendations and has rebilled and collected undercharges in the
                                     past. Therefore, since DOD policy and the contractual terms provide for
                                     adjustments to an FMS case, even if it has been closed, and DOD has
                                     collected undercharges in the past, DOD should make every reasonable
                                     attempt to recover the past undercharges for civilian pension and
                                     postretirement health benefit costs. In this regard, DOD should first
                                     consider the cost effectiveness of determining how much each FMS
                                     customer was undercharged.


                                     DOD’s stabilized rate policy, if applied properly, should allow WCF activities
Conclusions                          to recover the full cost of their operations over the long term. However,
                                     the stabilized rate should be adjusted to include all pension and




                                     Page 9                                       GAO/AIMD-97-134 Foreign Military Sales
                      B-275670




                      postretirement health benefit costs to the U.S. government for items sold
                      or services provided to FMS customers. DOD recognizes that these
                      additional retirement benefit costs, whose omission has resulted in
                      millions of dollars of undercharges, should be charged to FMS customers,
                      and is in the process of revising its policy to require that these costs be
                      included in future rates.


                      We recommend that the Secretary of Defense direct the Under Secretary
Recommendations       of Defense (Comptroller) to

                  •   implement the stabilized rate policies and procedures as soon as possible
                      to require WCF activities to include pension and postretirement health
                      benefit costs in the prices they charge FMS customers, and
                  •   make every reasonable attempt to bill for and collect the undercharges for
                      pension and postretirement health benefit costs identified in this report.
                      Such action should be taken only if cost effective to do so.


                      DOD concurred with our findings and recommendations. The Acting Under
Agency Comments       Secretary of Defense (Comptroller) agreed that DOD should have been
                      charging FMS customers for civilian retirement and postretirement health
                      benefits and issued guidance on August 27, 1997, instructing that these
                      charges be added to DOD’s prices effective immediately. The Acting Under
                      Secretary also requested that DSAA and the military services review FMS
                      cases, going back through fiscal year 1992, and bill the FMS customers for
                      the costs of civilian retirement and postretirement health benefits where
                      cost effective.

                      We are sending copies of this report to the Chairmen and Ranking
                      Minority Members of the Senate Committee on Armed Services, the Senate
                      Committee on Governmental Affairs, the House Committee on National
                      Security, the House Committee on Government Reform and Oversight, and
                      the House and Senate Committees on Appropriations; the Secretary of
                      Defense; the Director of the Office of Management and Budget; and other
                      interested parties. We will make copies available to others upon request.




                      Page 10                                    GAO/AIMD-97-134 Foreign Military Sales
B-275670




Please contact me at (202) 512-6240 if you or your staff have any questions
concerning this report. Other major contributors to this report are listed in
appendix II.

Sincerely yours,




Jack L. Brock, Jr.
Director, Defense Information and
Financial Management Systems




Page 11                                    GAO/AIMD-97-134 Foreign Military Sales
Appendix I

Comments From the Department of Defense




             Page 12        GAO/AIMD-97-134 Foreign Military Sales
Appendix I
Comments From the Department of Defense




Page 13                                   GAO/AIMD-97-134 Foreign Military Sales
Appendix II

Major Contributors to This Report


                       Larry W. Logsdon, Assistant Director
Accounting and         Harold P. Santarelli, Senior Auditor-in-Charge
Information            Cristina T. Chaplain, Communications Analyst
Management Division,
Washington, D.C.
                       Frank Maguire, Senior Attorney
Office of General
Counsel




                       Page 14                                  GAO/AIMD-97-134 Foreign Military Sales
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              Page 15                                   GAO/AIMD-97-134 Foreign Military Sales
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(511613)   Page 16                                 GAO/AIMD-97-134 Foreign Military Sales
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