oversight

Contract Management: A Comparison of DOD and Commercial Airline Purchasing Practices

Published by the Government Accountability Office on 1999-11-29.

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

                  United States General Accounting Office

GAO               Report to Congressional Requesters




November 1999
                  CONTRACT
                  MANAGEMENT

                  A Comparison of DOD
                  and Commercial
                  Airline Purchasing
                  Practices




GAO/NSIAD-00-22
United States General Accounting Office                                                          National Security and
Washington, D.C. 20548                                                                    International Affairs Division



                                    B-280496                                                                                       Leter




                                    November 29, 1999

                                    The Honorable James Inhofe
                                    Chairman
                                    The Honorable Charles Robb
                                    Ranking Minority Member
                                    Subcommittee on Readiness and Management Support
                                    Committee on Armed Services
                                    United States Senate

                                    The Department of Defense (DOD) is increasing the use of commercially
                                    available products and services. While the current level of commercial
                                    purchasing is relatively small—about 5 percent of the $2.6 billion spent on
                                    aircraft spare parts in fiscal year 19981—the Department expects such
                                    purchases to increase in the future and believes determining fair and
                                    reasonable prices for commercial sole-source items will be particularly
                                    challenging.

                                    Because of concerns over the pricing of spare parts for DOD aircraft, you
                                    requested that we compare the purchasing and pricing practices of selected
                                    commercial passenger and freight airline companies with those of DOD.
                                    We placed particular emphasis on how airlines and Defense ensure that
                                    they are obtaining reasonable prices when buying commercial items from
                                    sole-source suppliers.

                                    Our analysis of airline practices is based on discussions with officials from
                                    10 airlines. Our analysis of DOD’s buying practices is based on a case study
                                    review of 65 sole-source purchases at 7 Department buying centers.2 The
                                    assessment of DOD’s buying practices differs from the assessment of
                                    airline practices in that the Defense assessment covers both procurement



                                    1
                                     From the Department’s DD 350 procurement database, which covers contract actions over
                                    $25,000. Aircraft parts were defined as covering the following federal supply classes: 1560
                                    (aircraft structural components); 16xx (aircraft components and accessories); 2620 (aircraft
                                    pneumatic tires and tubes); and 2915, 2925, 2935, 2945, 2950, and 2995 (aircraft engine
                                    accessories).
                                    2
                                      See Contract Management: DOD Pricing of Commercial Items Needs Continued Emphasis
                                    (GAO/NSIAD-99-90, June 24, 1999).




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                   policies and their implementation. The airline assessment covers only
                   procurement policies.



Results in Brief   Airlines use a variety of practices to obtain spare parts at reasonable
                   prices. These practices include analyzing prices, procuring competitively,
                   utilizing catalog prices (commonly discounted), negotiating long-term
                   agreements, purchasing new surplus or reconditioned parts, and
                   sometimes asking for justifications of price increases. When faced with a
                   sole-source supplier demanding a price that they believe is unreasonable,
                   some airlines will consider re-engineering the part and establishing a
                   second source.

                   Department of Defense policies call for using similar practices when
                   buying commercial spare parts. Contracting officers often rely on
                   competition to ensure reasonable prices: about 42 percent of fiscal year
                   1998 spending on commercial spare parts for aircraft was awarded through
                   full and open competition. The Department frequently receives discounts
                   on catalog prices from suppliers, including sole-source suppliers. It has
                   also begun to negotiate longer-term agreements that set prices. In sole-
                   source situations, contracting personnel perform some price analyses, but
                   our recent review of these analyses indicated they could be very limited in
                   scope. Less commonly, the Department will purchase surplus parts or
                   consider re-engineering a part.



Background         In the absence of competition, DOD has traditionally been able to rely on
                   cost data to ensure that the prices it pays for spare parts are fair and
                   reasonable. When DOD purchases noncommercial items, contractors may
                   be required to provide certified cost or pricing data.3 In fiscal year 1998,
                   DOD obtained certified cost and pricing data for two-thirds of contract
                   dollars awarded (for noncommercial aircraft parts) without full and open
                   competition.4 By statute, suppliers of commercial items are not required to
                   submit certified cost or pricing data.




                   3
                    10 U.S.C. 2306a defines cost or pricing data as all facts that prudent buyers and sellers
                   would reasonably expect to significantly affect price negotiations.
                   4
                       From the DD 350 database, based on dollar value of contracts awarded.




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Commercial airlines buy spare parts to support aircraft maintenance and
use a variety of methods to service and maintain aircraft. Nearly all the
airlines we contacted said they perform 90 to 100 percent of routine aircraft
maintenance in-house. Most airlines we surveyed buy the bulk of their
spare parts (80-90 percent) to support these operations directly from
suppliers rather than through third parties. Some larger airlines also do
heavy maintenance, overhauls, and major modifications in-house, buying
spare parts for these tasks. Several smaller airlines contract these services
out using contracts that sometimes include spare parts. In addition,
airlines’ contracts for service on repairable parts often include new parts.

A majority of the airlines we contacted also participate in component
lease/service arrangements such as “power-by-the-hour,” “cost-per-
landing,” and “cost-per-cycle.” Under these agreements, major components
such as engines, wheels and brakes, and other components are leased from
a provider that charges by the hours of use or by the number of landings or
cycles. These agreements may include parts as well as service, but the
specific arrangements vary among the airlines. For example, some airlines
contract for a total parts and service package, while others allow the
service provider to supply only the less costly consumable parts. The latter
airlines purchase the more expensive spare parts themselves. Still other
airlines contract for a maintenance service package that may or may not
include parts but do some of the maintenance themselves.

Balancing the need to maintain minimum inventory with the need to avoid
aircraft grounded by the unavailability of spare parts is the key challenge
for spare parts management. Airlines reported using just-in-time inventory
procedures to eliminate excessive inventories and reduce costs. Under
just-in-time inventory management, parts are held by the supplier and
delivered just prior to scheduled maintenance. At the same time, to
minimize the possibility of an emergency aircraft-on-the-ground situation
due to unavailability of parts, some airlines stock a limited number of
critical items in case the supplier cannot rapidly deliver them.




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Purchasing Practices     In interviews with 10 airlines,5 we were told that airlines employ a variety
                         of practices to obtain spare parts at reasonable prices. These practices
of Commercial Airlines   include

                         •   price and part analyses,
                         •   competitive procurements,
                         •   relying on catalog prices (commonly discounted to airlines),
                         •   long-term agreements with suppliers, and
                         •   obtaining new surplus or reconditioned parts.

                         Airline officials said that when they are faced with purchasing parts from a
                         sole-source supplier at a price they determine to be excessive, in addition
                         to trying to negotiate long-term agreements or searching for surplus parts,
                         they may

                         • request cost and pricing data or justifications and/or
                         • re-engineer the part and develop a second source.

                         In some instances, these strategies are not feasible or not effective in
                         obtaining reasonable prices from sole-source suppliers. Although they
                         attempt to use the leverage of future business to encourage concessions,
                         airlines are sometimes forced to pay the price demanded by the sole-source
                         supplier.

                         All airlines we talked with said they buy some of their parts from sole-
                         source suppliers. Their estimates of how frequently they buy from such
                         suppliers varied from 5 to 75 percent. Those airlines flying older aircraft
                         tend to rely less on sole-source suppliers.

                         Several factors influence the purchasing practices employed by airlines.
                         Airlines that fly newer aircraft tend to be limited to purchases from the
                         original part manufacturer. They often rely on catalog prices or negotiate
                         long-term agreements with suppliers. Airlines flying older aircraft have
                         additional options. They may use manufacturers other than the original
                         equipment manufacturer or purchase surplus parts from other airlines or
                         brokers. When parts are available from multiple sources, competitive


                         5
                          Airborne Express, Alaska Airlines, American Airlines, Aloha Airlines, Delta Air Lines,
                         Federal Express, Hawaiian Airlines, Polar Air Cargo, United Airlines, and United Parcel
                         Service.




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                          procurement is feasible. Airline policies also affect the choice of
                          procurement practices. Some airlines are reluctant to buy surplus or
                          reconditioned parts and prefer original equipment manufacturers to ensure
                          quality; they use other sources only as an exception.

                          Airlines also said they will pay a premium price for a part if they have an
                          extremely urgent requirement. When an aircraft-on-the-ground situation
                          occurs, airlines will pay premiums of 15 to 25 percent to get the part within
                          hours. This premium does not include the cost of delivery, which can be
                          substantial. However, an aircraft that remains grounded can lead to the loss
                          of significant revenues. Airline inventory management practices aim to
                          minimize or avoid aircraft-on-the-ground situations while simultaneously
                          minimizing the resources tied up in inventory.

                          Several airline officials commented that while the greatest price leverage is
                          available when they purchase aircraft or major components (i.e., engines),
                          it is rarely used. These officials said that it was in their best financial
                          interest to get the lowest possible price for the initial purchase and that
                          negotiating a reduction in future spare parts prices usually means
                          increasing the cost of the initial buy. However, some airline officials
                          commented that they encourage aircraft manufacturers to provide direct
                          access to suppliers or to dual-source important components and parts.


Price and Part Analyses   Airlines uniformly reported that they analyze price histories of parts they
                          have bought to assess the reasonableness of a price. Airlines track price
                          histories and review them when procuring a particular part. They also
                          compare the offered price against the price of similar parts. Airlines also
                          said they search various electronic databases to research offered prices.

                          Airline officials emphasized that they examine non-price factors such as
                          delivery time and technical support in assessing the value of a part. The
                          assessment of reasonableness is thus based on overall value, including
                          price, quality, quantity, availability, location, delivery time, technical
                          support, warranty, and (if it is a used part) documentation and certification
                          of the part’s history.

                          Airlines may also involve their engineering staff in analyzing how much a
                          part should cost to manufacture. Purchasing staff are generally aware of
                          trends in material and other costs that affect manufacturing costs. These
                          analyses may be used to challenge the offered price and negotiate a lower
                          one.



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Competitive Procurement   Some airlines emphasized that they rely on competition to ensure
                          reasonable prices. These airlines establish thresholds governing when
                          competition is required. For example, several airlines said they solicit three
                          offers for all procurements over $10,000.


Catalog Prices            Virtually all airlines pay catalog prices for some parts, and they usually
                          receive discounts on the catalog price. Some airline officials stated that
                          they pay catalog prices for a majority of their spare part purchases. These
                          airlines tend to fly newer aircraft and rely on original equipment
                          manufacturers. In contrast, some airlines report buying less than
                          20 percent of their parts on the basis of catalog prices. These airlines have
                          other agreements with suppliers or use alternative manufacturers and new
                          surplus or reconditioned parts. Some parts are only available from a single
                          source and are catalog-priced.

                          Several airline officials emphasized that they carefully scrutinize what is
                          included in the catalog price, which may include shorter delivery times or
                          more support services than they require. Others said they accept the
                          catalog price and negotiate for additional services. Some said they analyze
                          the reasonableness of a catalog price and sometimes challenge it if they
                          conclude it is out of line.

                          Airlines, as final users (rather than distributors), commonly receive a
                          discount off the catalog price. Discounts can vary from 5 to 40 percent,
                          with deeper discounts resulting from high usage, dollar value of business,
                          or long-term agreements. Some airlines said they could find lower prices on
                          low-usage items from distributors, who have a larger business base and can
                          buy in larger quantities. Airline officials said they pay full catalog prices on
                          some sole-source items.


Long-term Agreements      Many airlines stated they negotiate long-term agreements with their more
                          frequent suppliers. These agreements vary in length. Some cover a 1- to
                          2-year period, while others cover 3 to 5 years.

                          Agreements that are shorter in length (1 to 2 years) usually lock in prices
                          and delivery schedules. The longer 3- to 5-year agreements tend to involve
                          an exclusive buying commitment. These longer-term agreements tend to
                          cover prices, delivery schedules, and support and may also have provisions
                          for the supplier to hold inventory for the airline. Agreements can aid



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                            airlines in obtaining lower prices based on the quantities procured or can
                            induce a sole-source supplier to lower prices to obtain more business.

                            Airlines differ in their reliance on long-term supplier agreements. One
                            airline said it tries to put many of its regular suppliers under agreements
                            and sees the agreements as an effective arrangement for obtaining
                            reasonable prices from sole-source suppliers. Others have few such
                            agreements.


Surplus and Reconditioned   Some airlines said they use new surplus and/or reconditioned spare parts
Parts                       to control costs. These airlines use such parts as alternatives to high-cost
                            sole-source items. Airline officials said that surplus and reconditioned
                            parts are more readily available for older aircraft.


Cost and Pricing Data       Few airlines request cost or pricing data, saying that suppliers are generally
                            unwilling to supply such data. Those that have requested data reported that
                            suppliers are usually not cooperative in providing it. According to an airline
                            association official, airlines may be successful in obtaining some data if
                            there is a reliability or quality issue prompting the request.

                            Some airlines stated they do request cost or pricing justifications and are
                            successful in obtaining them. Suppliers may sometimes provide
                            information on changes in material or labor costs that can trigger price
                            increases.


Re-engineering Parts        In selected circumstances, airlines will reverse-engineer a part (i.e.,
                            develop engineering or design specifications) and establish a second
                            source for it or manufacture the part themselves. Airline officials said it is
                            expensive to create a new manufacturing source and that long lead times
                            are required. The price of the part has to be excessively high and future
                            purchases substantial enough to justify the expense. They said that most of
                            the time, other strategies are successful in obtaining more reasonable
                            prices. Even when negotiations are unsuccessful, airline officials said that
                            the airlines may be better off accepting the offered price.




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DOD Practices   DOD employs many of the same practices used by commercial airlines in
                procuring spare parts. Like commercial airlines, DOD has limited leverage
                in negotiating with sole-source suppliers.

                The Federal Acquisition Regulation (FAR) requires contracting officers to
                perform sufficient price analyses to determine whether offered prices are
                fair and reasonable, while at the same time granting them wide latitude in
                the types of analysis techniques and extent of analysis they carry out. The
                FAR defines price analysis as the process of examining and evaluating a
                proposed price without evaluating its separate cost elements or profit.
                Price analysis techniques include (1) comparing proposed prices in
                response to a competitive solicitation; (2) comparing a currently offered
                price to previously paid prices if both the validity of the comparison and
                the reasonableness of the previous prices can be established; (3) using
                parametric methods such as dollars per pound or other measurement units;
                (4) comparing offers to competitive published price lists, published market
                prices, and discount or rebate arrangements; (5) comparing proposed
                prices with independent government cost estimates; and (6) comparing
                proposed prices with prices obtained through market research for the same
                or similar items. The FAR allows contracting officers to ask contractors to
                provide (when needed) sales prices for the same or similar items, an
                explanation of their discount policy, or cost data (but not certified cost and
                pricing data). Thus, the range of actions called for in the FAR covers many
                of the practices employed by airlines, including analyses of price histories,
                market research, independent cost analyses, and competitive procurement.

                Because of concerns about excessive price increases, each of the military
                services and the Defense Logistics Agency issued additional guidance
                between June and August 19 on the pricing of commercial items. The
                guidance cautions contracting officers on the need to fully understand the
                basis of commercial catalog prices and not assume that prices are fair and
                reasonable just because they are in a published commercial catalog. The
                guidance also stresses the importance of negotiating prices when buying
                commercial items.

                In practice, contracting officers tend to rely to a significant degree on
                competition to ensure price reasonableness. About 42 percent of fiscal year
                1998 contract dollars spent on commercial spare parts for aircraft were
                awarded through full and open competition. In contrast, only 9 percent of
                contract dollars spent on noncommercial aircraft parts were awarded
                through full and open competition.



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While the FAR and other guidance allow the use of a variety of other
practices to ensure price reasonableness, contracting officers tend to rely
on a more limited range of practices. In our June 1999 report, we discussed
the extent of price analysis performed by DOD contracting personnel when
procuring commercial sole-source items. We reported that in 33 of the 65
purchases we reviewed, price analysis consisted of comparing the offered
price with an offeror’s catalog or price list and/or with the prices the
government previously paid for the same or similar items. Contracting
officers accepted the offered price in 30 of the 33 purchases and negotiated
lower prices in only 3 cases. In the other 32 purchases, contracting
personnel used one or more additional price analysis tools such as
commercial sales information. Contracting officers accepted the offered
price in 19 of the 32 purchases and negotiated lower prices in 13 cases.

We also found that the price analyses performed by contracting personnel
were often too limited to ensure that prices were fair and reasonable. For
example, some contracting personnel believed that when the offered price
was the same as the catalog or list price, it could be considered fair and
reasonable. In several cases, contracting personnel did not use pertinent
historical pricing information (in the contract files) that could have been
used to raise questions about the reasonableness of offered prices. In one
instance, the offered price increased 548 percent from the price paid
9 years earlier, while in another case, the offered price increased
475 percent. We also identified cases in which contracting officers paid
prices that included unneeded services such as rapid delivery. Moreover,
contracting officers generally did not include a clause in the solicitation
requiring offerors to provide, upon request, information other than certified
cost and pricing data, such as sales data or the basis of the offered price, in
support of their offered prices. Defense Logistics Agency guidance
recommends this clause in all solicitations and contracts for sole-source
commercial items.

Of the 65 cases we reviewed, a catalog or list price was available for 48
items. In 10 cases, DOD received no discount, while in the remaining 38
cases, DOD received discounts ranging from 5 percent to 73 percent off the
catalog price. The discounts were based primarily on the quantities
purchased.

DOD activities are also beginning to make use of long-term agreements to
take advantage of the Department’s leverage as a large customer. For
example, the Defense Logistics Agency uses long-term agreements known
as corporate contracts for a number of different engine and aircraft spare



Page 9                                      GAO/NSIAD-00-22 Contract Management
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                  parts. These contracts aggregate the requirements of one or more supply
                  centers with a single supplier of multiple items. The contracts cover not
                  only pricing but also distribution and delivery services. They may address
                  specific spare parts or include a manufacturer’s entire commercial price
                  list. By using these contracts, the Defense Logistics Agency expects to
                  lower its costs, obtain better delivery times, and reduce its customer
                  support infrastructure.

                  The Defense Logistics Agency makes limited use of surplus parts. It buys
                  such parts infrequently and usually for older aircraft.

                  DOD policy allows the re-engineering of parts when significant savings can
                  be demonstrated. Officials stated that this is an expensive undertaking and
                  is rarely used. However, DOD can determine how much a part should cost.
                  For example, one Navy unit6 provides “should-cost” and other price
                  analyses for Navy and Defense Logistics Agency contract officers on
                  request. This unit can also re-engineer simple parts.



Agency Comments   We requested comments from the Department of Defense on
                  September 30, 1999. On October 26, 1999, we were told by DOD’s Office of
                  Inspector General that DOD concurs with the report and would not be
                  providing further comments. We also shared the draft report with airline
                  officials who had participated in our review. These officials commented
                  that the report accurately captures the set of tools that airlines use to
                  acquire spare parts.



Scope and         To identify the spare parts purchasing and pricing practices of commercial
                  airlines, we contacted 10 commercial air carriers, including the largest
Methodology       passenger and cargo air carriers. We visited three airlines to observe and
                  discuss their spare parts buying operations and contacted the others by
                  telephone. We obtained much of the data through interviews with
                  commercial airline spare parts buyers, purchasing supervisors, managers,
                  and directors. The fleet size of the airlines we contacted ranged from 13 to
                  over 600 aircraft, and sales volumes ranged from approximately $250
                  million to $25 billion.


                  6
                    Price Fighters Department, Fitting Out and Supply Support Assistance Center, Navy Supply
                  Systems Command.




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In addition, we discussed commercial practices with officials of four
aircraft industry trade associations: the Air Transport Association of
America, the Airline Suppliers Association, the Aerospace Industries
Association, and the National Defense Transportation Association. The first
2 represent 95 percent of U.S. passenger and cargo air traffic and over 200
airline suppliers, respectively.

We also reviewed a comparative analysis of commercial buying practices
prepared by Arthur Andersen’s Government Services Division to cross-
check the information we obtained. The report, titled World Class
Commercial Buying Practices Review for Defense Contract Management
Command, was published September 17, 1998.

We compared the information obtained from commercial airline companies
and organizations with the results of a review we recently completed
involving case studies of 65 contract actions undertaken at 7 DOD buying
centers:

•   Air Force Air Logistics Center, San Antonio, Texas;
•   Air Force Air Logistics Center, Oklahoma City, Oklahoma;
•   U.S. Special Operations Command, Fort Eustis, Virginia;
•   Defense Supply Center, Columbus, Ohio;
•   Defense Industrial Supply Center, Philadelphia, Pennsylvania;
•   Defense Supply Center, Richmond, Virginia; and
•   Naval Inventory Control Point, Philadelphia, Pennsylvania.

The first six were selected because they were major purchasers of
commercial sole-source parts for aircraft. The seventh was selected
because it was located at the same address as the Defense Industrial
Supply Center in Philadelphia.

We judgmentally selected for review 65 sole-source commercial purchases
of over $100,000 where the price was negotiated during fiscal years 1997-98.
For each purchase, we reviewed information in the contract file, including
the price analysis and negotiation memorandums, and discussed this
information with contracting personnel.




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We are sending copies of this report to the Honorable William Cohen,
Secretary of Defense; the Honorable Jacob Lew, Director, Office of
Management and Budget; and Lieutenant General Henry T. Glisson,
Director, Defense Logistics Agency. Copies will also be made available to
others on request.

If you have any questions regarding this report, please contact me at
(202) 512-4841. Key contact and contributors to this report are listed in
appendix I.




David E. Cooper
Associate Director
Defense Acquisition Issues




Page 12                                    GAO/NSIAD-00-22 Contract Management
Page 13   GAO/NSIAD-00-22 Contract Management
Appendix I

GAO Contact and Staff Acknowledgments                                                            AA
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GAO Contact           Karen S. Zuckerstein (202) 512-6785



Acknowledgments       In addition to the name above, Dorian Dunbar, Paul Greeley, Paula
                      Haurilesko, and Thaddeus Rytel made key contributions to this report.




(707365)      Leter   Page 14                                  GAO/NSIAD-00-22 Contract Management
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