oversight

Military Aircraft: Observations on DOD's Aerial Refueling Aircraft Acquisition Options

Published by the Government Accountability Office on 2003-10-14.

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

United States General Accounting Office
Washington, DC 20548




                                   October 14, 2003 


                                   The Honorable John Warner 

                                   Chairman 

                                   The Honorable Carl Levin 

                                   Ranking Member 

                                   Committee on Armed Services 

                                   United States Senate 


                                   Subject: Military Aircraft: Observations on DOD’s Aerial Refueling
                                   Aircraft Acquisition Options

                                   During the Senate Armed Services Committee’s September 4, 2003 hearing
                                   on the Department of Defense’s (DOD) proposed lease of 100 Boeing
                                   KC-767A aerial refueling aircraft, you expressed concern about a
                                   significant “bow-wave” funding requirement in future years to pay for
                                   leasing and then buying these 100 aircraft at the end of their leases, while
                                   continuing efforts to modernize the remainder of the tanker fleet.
                                   Subsequently, you requested that DOD analyze the option of leasing
                                   25 aircraft, followed by a procurement of the remaining 75 aircraft.
                                   The Deputy Secretary of Defense responded to your request on
                                   September 22, 2003, identifying several alternative acquisition strategies,
                                   with associated cost and savings estimates. On September 25, 2003, you
                                   asked that GAO review the DOD response and assess the validity of the
                                   department’s assumptions and the accuracy of the cost and savings
                                   estimates, and identify any other alternative acquisition strategies that the
                                   Committee should consider. This letter responds to your request.

                                   DOD’s response compared the six acquisition options offered by the
                                   Deputy Secretary to acquire 100 KC-767A aircraft: (1) leasing all
                                   100 aircraft as outlined in the Air Force plan reported to the Congress in
                                   July 2003; (2) purchasing all 100 aircraft at the time of order under the
                                   same multiyear conditions as the lease; (3) leasing the first 25 aircraft and
                                   purchasing the remaining 75 when the order is placed; (4) leasing the first
                                   25 aircraft and purchasing the remaining 75 when the aircraft are
                                   delivered; (5) leasing 25 aircraft, followed by a traditional multiyear
                                   procurement of 75 aircraft under a separate contract, and (6) leasing all




                                   Page 1                                            GAO-04-169R Military Aircraft
          100 aircraft initially, then planning to seek $2.4 billion between fiscal years
          2008-2010 to purchase 26 of the 100 aircraft.1

          To perform our work, we met with DOD and Air Force officials to obtain
          details on these options, including the assumptions and information used
          to generate the cost and savings estimates contained in DOD’s response.
          We also conducted our own independent analysis. See enclosure I for
          more details on our scope and methodology.


          In our opinion, the assumptions used by DOD to develop its analysis of
Summary   acquisition options generally appear to be reasonable, and the
          computations of the cost and savings estimates associated with these
          options appear to be accurate based on the current terms and conditions
          of the negotiated lease. We do believe, however, that the costs and
          savings numbers could be further refined under the options involving
          purchase. For example, Air Force officials indicated that The Boeing
          Company would pay the cost to underwrite the issuance of the bonds
          needed for financing in the original lease option. However, they could not
          definitively say whether the underwriting costs were included in the
          $131 million price for each aircraft. Because fewer bonds, if any, would be
          issued under the options involving purchase, the costs should be lower
          and the savings higher.

          With the exception of the fifth option—Chairman Warner’s suggestion of
          leasing 25 aircraft, followed by a purchase of the remaining 75 aircraft at
          delivery—DOD did not significantly deviate from the costs, schedules, and
          support provisions contained in its July 10, 2003 report to the Committee
          and the Congress. Air Force officials stated that their analysis of options
          complied with the Chairman’s request and that analyses outside the
          proposed lease’s terms and provisions would be academic exercises that
          might not be representative of the final negotiated prices. These officials
          also stated that changes from the proposed contract would require new
          negotiations and new review and approval actions, and consequently
          would lead to additional delays.




          1
           Figures 4 and 5 of the Deputy Secretary’s letter also mentioned another version of this—
          to identify $2 billion in fiscal year 2008-2009, but this option was not discussed in the
          narrative of the letter.




          Page 2                                                     GAO-04-169R Military Aircraft
                          In addition to the options presented by DOD, we believe two other
                          possible approaches—lease fewer tankers or purchase tankers on a slower
                          schedule—may be of interest to the Congress. Both options would involve
                          fewer than 100 aircraft—one through leasing and one through direct
                          purchase. Both options have advantages and disadvantages that we have
                          not fully explored in the time available.


Our Assessment of DOD’s   In our opinion, the assumptions used by the DOD to develop its analysis
Analysis                  of acquisition options generally appear to be reasonable, and the
                          computations of the cost and savings estimates associated with these
                          options appear to be accurate based on the current terms and conditions
                          of the negotiated lease. Table 1 summarizes DOD’s estimated costs and
                          savings for the six options it considered, followed by our observations on
                          the approach, data, and assumptions used. As indicated in table 1, the
                          current proposal being considered by the Congress for the Air Force—the
                          lease of 100 KC-767A aircraft for 6 years each, followed by their purchase
                          at the end of the lease—is the most costly of the options over the next
                          decade, requiring about $29.8 billion (then-year dollars). As we have
                          testified,2 leasing requires the least up-front funding to the 2004-2009
                          Future Years Defense Program (FYDP), about $5.5 billion (then-year
                          dollars). While purchase of the 100 aircraft would cost the least amount
                          over the long term—$24.3 billion, or $5.5 billion less than the lease, it
                          would require the largest up-front increase to the FYDP—nearly
                          $13 billion more than the lease option. DOD approved the lease proposal,
                          at least in part, because it requires the least amount of up-front funding for
                          refueling aircraft while keeping the funding for other programs intact.




                          2
                           Military Aircraft: Observations on the Proposed Lease of Aerial Refueling Aircraft by
                          the Air Force. GAO-03-923T. Washington, D.C.: September 4, 2003.




                          Page 3                                                   GAO-04-169R Military Aircraft
Table 1: Options and Cost Comparisons (then-year dollars in billions)

                                                                                                                                  Savings over current
                                                                                      a                             b
 Options                                                       Cost during FYDP                      Total costs                       lease proposal
 1. Lease 100                                                                      5.5                         29.8                                NA
 2. Purchase 100                                                                 18.4c                         24.3c                               5.5
 3. Lease 25/buy 75, pay when order                                               16.6                         25.6                                4.2
 4. Lease 25/buy 75, pay at delivery                                              10.1                         26.3                                3.5
                                                                                                                    c
 5. Separate contracts (lease 25, buy 75)                                         16.0                         27.1                                2.7
 6. Lease with $2.4 billion increase                                               7.5                         28.6                                1.2
Source: GAO analysis of Air Force data.
                                               a
                                                   Aircraft cost only. Includes cost of purchasing leased aircraft at end of lease.
                                               b
                                                   Includes operating and support costs, other government costs, and military construction.
                                               c
                                                   Assumes that multi-year procurement authority was granted.


                                               We have the following comments and observations on DOD’s options:

                                          •	  The estimated costs and savings for all options except for number 5 are
                                              based on the cost figures from the currently negotiated lease with Boeing.
                                              Based on our analysis, we believe these represent a reasonable estimate of
                                              the likely total costs and savings in then-year dollars. We do think,
                                              however, that the costs and savings numbers could be further refined in
                                              the options involving purchase or lease. For example, Air Force officials
                                              indicated that The Boeing Company would pay the cost to underwrite the
                                              issuance of the bonds in the original lease option. However, they could not
                                              definitively say whether the underwriting costs were included in the $131
                                              million price for each aircraft. Because fewer bonds, if any, would be
                                              issued under the options involving purchase, the costs should be lower
                                              and the savings higher.
                                          • 	 The fifth option entails a contract for leasing 25 aircraft followed by a
                                              separate contract for a traditional multi-year procurement. With this
                                              option, Air Force officials stated that the capital markets may not support
                                              the lease because of risk concerns, particularly in exercising the option to
                                              buy the planes at the end of the lease, and, therefore, the option is
                                              potentially unexecutable. In examining this concern, we would point out
                                              that 90 percent of the present value of the fair market value of the aircraft
                                              will have been paid at the end of their 6-year leases, and it would make
                                              little sense not to purchase the planes. Also, given the long-term need to
                                              replace the tanker fleet, it is unlikely that the planes would not be
                                              purchased at the end of the lease.
                                          • 	 All of the options except for number 5 assume delivery of 60 aircraft
                                              during the FYDP period on the same delivery schedule. DOD believes


                                               Page 4                                                                   GAO-04-169R Military Aircraft
     option 5 would require new negotiations, internal and external review, and
     congressional approval—a process that could take as long as a year and
     could result in higher prices than currently negotiated for the lease of
     100 aircraft. Because of this potential delay, DOD also estimates that this
     option would result in delivery of only 40 aircraft during the FYDP period.
     Based on our analysis, we believe the costs and savings estimates by the
     Air Force are more speculative for this option. It is unclear to us why the
     process to negotiate and process the changes would take so long to gain
     final approval. Also, any purchase of the aircraft, including those specified
     in each of the other options, required congressional approval.
•	   As presented by DOD, all the options considered represent a trade-off
     between more up-front budget authority during the FYDP period and more
     potential savings over the life of the program.
•	   All of the options except for number 5 assume the same early delivery
     schedule as the currently proposed lease; that is, the first 4 aircraft would
     be delivered at the end of fiscal year 2006, 16 in 2007, and 20 per year in
     subsequent years until 100 have been delivered. This assumes that it is
     more urgent to begin replacement of the tanker fleet now rather than
     proceed with the previously planned procurement schedule, which the Air
     Force has said would begin delivering aircraft in fiscal year 2009.
•	   DOD was not asked to and did not assess other options outside the terms
     and provisions of the existing lease, which could potentially provide
     additional cost savings. For example, what costs and savings might accrue
     if the number of KC-767A aircraft leased and/or procured varied from 100
     aircraft? How would competitive bidding by commercial airlines and
     independent maintenance, repair, and overhaul facilities for KC-767A
     maintenance and training support affect costs and savings? How would
     program costs change if the purchase price per plane was closer to the
     $120.7 million estimate postulated by the Institute for Defense Analyses,
     rather than the $131.0 million price contained in the contract?3
•	   The Deputy Secretary’s letter presenting the Air Force savings estimates
     states that the department proposes to find an extra $2.4 billion to buy out
     the leases for 26 aircraft in the 2008-10 timeframe. Air Force officials told
     us that DOD will try to identify these funds in the current FYDP and may
     even seek support from the Army, Navy, and Marine Corps. This is option
     number 6 in the table. DOD and Air Force acquisition officials we spoke
     with said that the Deputy Secretary of Defense’s letter to the committee
     represents a firm commitment to identify these funds in the fiscal year


     3
      At your request, we reviewed the Institute of Defense Analyses study and concluded that
     its methodology was reasonable. See Military Aircraft: Institute for Defense Analyses
     Purchase Price Estimate for the Air Force’s Aerial Refueling Aircraft Leasing Proposal.
     GAO-04-164R. Washington, D.C.: October 14, 2003.




     Page 5                                                    GAO-04-169R Military Aircraft
                      2008-2010 time frame. If the Congress agreed to that approach, it might
                      want more assurance that the increase in funding would really occur,
                      otherwise the savings will not materialize and the Congress may simply be
                      asked to provide additional budget authority.
                      The initial 100 KC-767A aircraft being discussed represent only about
                      20 percent of the KC-135 inventory. DOD and the Air Force have stated
                      that tanker replacement efforts need to continue beyond these aircraft,
                      and that this will be an expensive and lengthy undertaking. As a result, the
                      funding requirements for tanker replacement will extend for many years
                      beyond those addressed in the lease proposal, and will have to compete
                      with other high priority programs among the Air Force and the other
                      services in a fiscally-constrained environment. Thus, the Committee’s
                      concern about a tanker “bow wave” is appropriate and relevant as we
                      pointed out in our September 4, 2003 testimony, regardless of the option
                      chosen for the first 100 aircraft. The options involving a 25/75 split of
                      leased and purchased aircraft all have a positive effect on the “bow wave”
                      concern beyond fiscal year 2012, as was discussed at the September 4,
                      2003 hearing. By committing more funding in the early years of the
                      program, costs are reduced considerably in the out years. This should ease
                      the burden on budgets for follow-on procurements of tanker aircraft. The
                      proposal to plus up the budget by $2.4 billion to buy out 26 of the leases
                      also has a positive effect on reducing the bow wave, but not to as great an
                      extent as the other options. This approach still incurs costs in the $3
                      billion range in fiscal year 2011-13. To illustrate the effect of DOD’s various
                      options on this long-term spending picture, we have developed charts
                      showing the budget authority that would be required to execute the
                      acquisition of the first 100 aircraft followed by a subsequent purchase of
                      another 100 KC-767A aircraft. (See enclosure II).


                      The DOD response represents a reasonable analysis of the 25/75 split
Other Alternative 	   option and it offers an additional option—option number 6, which
Approaches 	          proposes to add $2.4 billion for tankers to be used to buy out leases for
                      26 aircraft. In effect, this would be a “lease 74/buy 26” approach. We
                      believe at least two additional options may be of interest to the committee
                      as it considers its decision. These include the following:




                      Page 6                                             GAO-04-169R Military Aircraft
•	  Lease fewer tankers. Section 8159 of the 2002 Act4 authorized a pilot
    program for leasing no more than 100 Boeing 767s as tankers. The act did
    not specify leasing 100; it set 100 as the maximum. A smaller leasing
    program would still meet the intent of the act, would be less expensive,
    would start replacement of the KC-135s, and most importantly, would
    allow some time for the Air Force to study tanker force requirements and
    conduct a thorough analysis of alternatives before committing to a large
    acquisition program.5 Such an approach would probably need to include
    leasing as many as 40 to 50 aircraft to provide sufficient time for the
    needed studies. This approach is still more expensive than purchase, and it
    might still involve the use of the special purpose entity6 to facilitate lease
    financing, but it allows the program to proceed with early delivery of
    aircraft without disruption to Air Force budgets in the short-term. We do
    not know what effect this approach would have on delivery schedules or
    whether Boeing would agree to the same lease terms for fewer aircraft.
• 	 Purchase tankers on a slower schedule. The Air Force plans to spend
    about $5.5 billion during the FYDP period for the proposed lease, and the
    Deputy Secretary stated in his letter to you that the department proposes
    to identify an additional $2.4 billion during this period to buy out some of
    the leases. If that total of $7.9 billion were applied toward purchase of
    tankers, it would represent a reasonable start toward replacing the tanker
    fleet through a normal acquisition process. Because the Boeing 767
    commercial aircraft has been in production since 1982 and thus represents
    little development risk, the Air Force should be able to negotiate a multi-
    year procurement for a substantial number of aircraft. This would not
    provide the same firm order for 100 aircraft in the current lease proposal,
    but it would still represent a large transaction for Boeing on its 767
    production line. However, this approach might involve delays in deliveries
    of the first aircraft, depending on how much budget authority is available


     4
       Department of Defense and Emergency Supplemental Appropriations for Recovery
     from and Response to Terrorist Attacks on the United States Act, Pub. L. 107-117, § 8159,
     115 Stat. 2230, 2284-85.
     5
       Section 309 of the Emergency Supplemental Appropriations for Iraq and Afghanistan
     Security and Reconstruction for Fiscal Year, 2004, S. 1689, 108th Cong. § 309 (2003),
     requires that the Secretary of Defense submit a report to the congressional defense
     committees describing an analysis of alternatives for replacing the capabilities of the fleet
     of KC-135 fleet aircraft. The Air Force has indicated, however, that it will probably initiate a
     tanker requirements study sometime between fiscal years 2004-2006, followed by a formal
     analysis of alternatives (AOA). Air Force officials have stated that a formal AOA could take
     up to two years to complete.
     6
      The Special Purpose Entity would be a trust created under the laws of Delaware that
     would issue bonds to raise sufficient capital to purchase the new aircraft from The Boeing
     Company and lease them to the Air Force.




     Page 7                                                        GAO-04-169R Military Aircraft
                       in fiscal year 04 and fiscal year 05. Deliveries might also have to be spread
                       over a longer period if the Air Force and DOD do not provide additional
                       funding priority for tankers. This approach, too, would provide the Air
                       Force some time to study tanker requirements and analyze options before
                       committing to a large program.

                       We could not develop costs for these two options in the time available. Air
                       Force officials believe that adoption of either of these options would delay
                       delivery of the first aircraft and further believe that while less costly in the
                       short term, the proposals could increase total program costs.


                       In oral comments on a draft of this correspondence, DOD and Air Force
Agency Comments 
      officials generally concurred with our analysis. These officials also pointed
and Our Evaluation 
   out that their analysis, as contained in the letter from the Deputy Secretary
                       of Defense, was limited specifically to the questions asked of them by you
                       although they have considered other options that were not included.


                       We conducted this work from September to October 2003 in accordance
                       with generally accepted government auditing standards.

                       Unless you announce its contents earlier, we plan no further distribution
                       of this letter until 10 days from its issue date. At that time, we will send
                       copies of this letter to the Chairman and Ranking Member of the
                       Committee on Armed Services, House of Representatives, and the defense
                       subcommittees of the Senate and House Committees on Appropriations.
                       We will send a copy to the Chairman, Subcommittee on Readiness, House
                       Committee on Armed Services, for whom we are conducting a broader
                       body of work in this area. We will also send copies to the Secretary of
                       Defense and the Director of the Office of Management and Budget. We will
                       also make copies available to other interested parties upon request. In
                       addition, the letter will be available at no charge on the GAO Web site at
                       http://www.gao.gov.




                       Page 8                                              GAO-04-169R Military Aircraft
We appreciate this opportunity to be of assistance. If you or your 

staffs have any questions regarding this letter, please contact me at 

(202) 512-4914 or Brian J. Lepore, Assistant Director, at (202) 512-4523. 

Other key contributors to this review were Ann M. Dubois, Joseph J. Faley,

Jennifer K. Echard, Kenneth W. Newell, Madhav S. Panwar, Charles W. 

Perdue, Kenneth E. Patton, and Tim F. Stone. 





Neal P. Curtin, Director 

Defense Capabilities and Management 


Enclosures 





Page 9                                          GAO-04-169R Military Aircraft
Enclosure I: Scope and Methodology 



              To assess the validity of the Department of Defense’s (DOD) assumptions,
              accuracy of cost and savings estimates associated with the various options
              addressed by the Deputy Secretary of Defense in his response to the
              Committee, and to identify alternative acquisition strategies, we met with
              DOD and Air Force officials to discuss detailed information related to the
              options. These discussions included the nature and scope of the options
              selected, as well as the assumptions and methodologies used in the
              analyses. We also obtained and reviewed Air Force data used to generate
              the cost and savings estimates contained in DOD’s response, validated that
              the data was appropriately included or excluded to support the details of
              the individual options chosen, tested the accuracy of the computations,
              and conducted our own independent analyses.

              To assess the funding impacts of the various options when combined with
              a subsequent purchase of 100 aircraft, we compared Air Force data for
              each of the options to a postulated buy of an additional 100 aircraft
              beginning in fiscal year 2012 at the rate of 20 aircraft per year. We used the
              Air Force’s purchase price for the aircraft, spread the payments for each
              aircraft over a 4-year period per Air Force data, and adjusted the data to
              reflect then-year dollars.




              Page 10                                            GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements

               Follow-on procurements to the initial lease of 100 aircraft will be a
               necessary part of any tanker replacement program. Because the funding
               requirements of the proposed lease are deferred until later years, those
               requirements will impact the requirements for subsequent tanker
               acquisitions. The following figures provide an approximate illustration of
               how the various options effect the funding requirements for future
               refueling aircraft purchases beyond the first 100.

               Figure 1: Annual Budget Authority Required to Initially Lease 100 Aircraft and to
               Purchase 100 Follow-On Aircraft




               Page 11                                                GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements




Combining a follow-on purchase of 100 aircraft with the Air Force’s
original proposal to lease 100 aircraft, would require maximums of about
$6.3 billion and $6.4 billion in budget authority in fiscal years 2012 and
2013 respectively, as shown in figure 1. About $3.6 billion would be
required during the current FYDP and a total of about $38.5 billion would
be required over the entire program.1




1
    These totals include only procurement costs and do not represent total program costs.




Page 12                                                      GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements




Figure 2: Annual Budget Authority Required to Purchase Both an Initial 100 And
Second Block of 100 Aircraft




Purchasing the initial 100 aircraft, when combined with a follow-on
purchase, would have the least impact on overall budget authority
requirements. As figure 2 shows, an initial purchase of 100 aircraft
followed by a subsequent purchase of an additional block of 100 aircraft
would require maximums of about $3.4 billion in budget authority in fiscal
years 2008 and 2013 to procure the aircraft. About $15.8 billion would be
required during the current FYDP and a total of about $33 billion would be
required over the entire program to procure the 200 aircraft.




Page 13                                              GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements




Figure 3: Annual Budget Authority Required to Lease 25 Aircraft and to Purchase
75 Aircraft at Time of Order and to Purchase 100 Follow-On Aircraft




Combining a follow on purchase of 100 aircraft with the alternative of
initially leasing 25 aircraft and purchasing 75 others, would require
maximums of about $4.1 billion and $4.3 billion in budget authority in
fiscal years 2012 and 2013, respectively, as shown in figure 3, if the
75 aircraft were paid for when ordered. About $14.5 billion would be
required during the current FYDP and a total of about $34.3 billion would
be required over the entire program.




Page 14                                              GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements




Figure 4: Annual Budget Authority Required to Lease 25 Aircraft and to Purchase
75 Aircraft at Time of Delivery and to Purchase 100 Follow-On Aircraft




Paying for the initial 75 aircraft in the previous option on delivery would
require maximums of about $5.6 billion and $6.7 billion in budget authority
in fiscal years 2010 and 2011, respectively, as shown in figure 4. About $8.1
billion would be required during the current FYDP and a total of about $35
billion would be required over the entire program.




Page 15                                              GAO-04-169R Military Aircraft
Enclosure II: Impact of Air Force Options on
Budget Authority Requirements




Figure 5: Annual Budget Authority Required To Initially Lease 25 Aircraft and to
Purchase the Remaining 75 Aircraft of the Initial Block under a Separate Contract
and to Purchase 100 Follow-On Aircraft




Combining a follow-on purchase of 100 aircraft with the option of initially
leasing 25 of the initial 100 aircraft and negotiating a separate contract for
the purchase of the remaining 75 aircraft of the initial block, would require
maximums of about $4.6 billion and $4.5 billion in budget authority in
fiscal years 2009 and 2013, respectively, as shown in figure 5. About
$14.4 billion would be required during the current FYDP and a total of
about $35.3 billion would be required over the entire program.




Page 16                                               GAO-04-169R Military Aircraft
           Enclosure II: Impact of Air Force Options on
           Budget Authority Requirements




           Figure 6: Annual Budget Authority Required to Initially Lease 74 Aircraft and to
           Purchase 26 Aircraft and to Purchase 100 Follow-On Aircraft




           Combining a follow-on purchase of 100 aircraft with the option of
           purchasing 26 of the initial 100 aircraft, would require maximums of about
           $5.5 billion and $5.7 billion in budget authority in fiscal years 2012 and
           2013, respectively, as shown in figure 6. About $5.6 billion would be
           required during the current FYDP and a total of about $37.3 billion would
           be required over the entire program.




(350450)
           Page 17                                                GAO-04-169R Military Aircraft
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