oversight

Air Force Depot Maintenance: Analysis of Its Financial Operations

Published by the Government Accountability Office on 1999-12-10.

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

                       United States General Accounting Office

GAO                    Report to the Chairman, Subcommittee
                       on Military Readiness, Committee on
                       Armed Services, House of
                       Representatives

December 1999
                       AIR FORCE DEPOT
                       MAINTENANCE

                       Analysis of Its
                       Financial Operations




GAO/AIMD/NSIAD-00-38
United States General Accounting Office                                                Accounting and Information
Washington, D.C. 20548                                                                      Management Division



                                    B-283840                                                                               Leter




                                    December 10, 1999

                                    The Honorable Herbert H. Bateman
                                    Chairman
                                    Subcommittee on Military Readiness
                                    Committee on Armed Services
                                    House of Representatives

                                    Dear Mr. Chairman:

                                    The Air Force depot maintenance activity group supports combat readiness
                                    by providing the depot repair services necessary to keep Air Force units
                                    operating worldwide. The group repairs and overhauls a wide range of
                                    assets including aircraft, missiles, aircraft engines, electronics, avionics,
                                    software, and repairable inventory items for military services, other
                                    government agencies, and foreign governments. For example, in fiscal year
                                    1998, the Air Force reported that the depot maintenance activity group
                                    performed major overhauls on about 670 aircraft, overhauled about
                                    980 engines, and repaired more than 800,000 inventory items. The group
                                    generates about $5 billion in annual revenue of which about $3.5 billion
                                    comes from in-house repair and services and about $1.5 billion comes from
                                    its contract repair operations.

                                    This report, one in a series1 you requested on the financial operations of the
                                    Department of Defense’s (DOD) Working Capital Funds, addresses the Air
                                    Force depot maintenance activity group. This group operates under the
                                    working capital fund concept, where customers are to be charged the
                                    anticipated actual costs of providing goods and services to them.

                                    As requested, this report discusses (1) the Air Force depot maintenance
                                    activity group’s price increase between fiscal year 1994 and fiscal year 1999
                                    and the primary reasons for it, (2) the activity group’s financial losses
                                    during fiscal year 1994 through fiscal year 1998 and the primary reasons for
                                    them, and (3) the Air Force’s methods for recovering these losses. We


                                    1
                                    We issued two reports on the Navy Ordnance activity group (GAO/AIMD/NSIAD-97-74,
                                    March 14, 1997, and GAO/AIMD/NSIAD-98-24, October 15, 1997) and two reports on the
                                    Air Force Supply Management Activity Group (GAO/AIMD/NSIAD-98-118, June 8, 1998, and
                                    GAO/NSIAD/AIMD-99-77, April 29, 1999).




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                   briefed your office on the results of our work on September 15, 1999. As
                   agreed, we are continuing our work and will evaluate the Air Force’s ability
                   to develop accurate estimates for work to be accomplished, material costs,
                   and anticipated savings that were used in developing depot maintenance
                   prices.



Results in Brief   The Air Force depot maintenance activity group’s prices increased from an
                   average of $92.60 per direct labor hour (DLH) in fiscal year 1994 to
                   $128.43 per DLH in fiscal year 1999—a 39 percent increase.2 The price
                   increase occurred primarily because (1) the direct material cost per direct
                   labor hour increased, (2) workload declined faster than overhead costs,
                   and (3) the average cost of civilian labor increased.

                   Even though the prices increased 39 percent, the Air Force reported that
                   the depot maintenance activity group lost about $623 million3 during fiscal
                   years 1994 through 1998 on total sales of about $21.8 billion. Our analysis
                   indicates that these losses occurred primarily because the activity group
                   (1) did not accomplish as much work as expected, (2) had material costs
                   that were higher than budget estimates, (3) developed prices based on
                   anticipated savings that were not realized, and (4) incurred losses on its
                   contract repair operations during fiscal years 1996, 1997, and 1998.

                   Since fiscal year 1995, the Air Force has tried different methods to recover
                   the depot maintenance activity group’s losses with varying success. For
                   fiscal years 1995 through 1997, the Air Force increased prices and
                   requested a direct appropriation. However, neither of these methods was
                   successful in recouping losses. Beginning in fiscal year 1998, the Air Force
                   used the following two other methods, which were more successful in
                   recovering losses.

                   • First, the Air Force developed the depot maintenance activity group’s
                     fiscal years 1998 and 1999 prices based on the group’s cost of operations
                     plus an amount to recover $310 million in prior year losses. The Air
                     Force then separated the approved fiscal years 1998 and 1999 prices into


                   2
                   If the fiscal year 1994 price is converted to fiscal year 1999 dollars, it would be $106.58 per
                   DLH. This would reduce the increase to 20.5 percent.
                   3
                    The $623 million loss includes a $98.8 million accounting adjustment that does not need to
                   be recovered.




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               two pieces. The first piece was the amount the activity group charged
               individual customers for current year work. The second piece was to
               recover the $310 million in prior year losses.
             • Second, pursuant to a new DOD policy that directs depot maintenance
               activities to recover losses that occurred during the year of execution,
               the Air Force (1) reprogrammed funds and (2) used other available
               customer appropriated funds to recover the depot maintenance activity
               group’s losses. As a result, the Air Force recovered or plans to recover
               $313.4 million in losses that occurred in fiscal years 1998 and 1999.



Background   The Air Force depot maintenance activity group is part of the Air Force
             Working Capital Fund, a revolving fund that relies on sales revenue rather
             than direct congressional appropriations to finance its operations. Working
             capital funds are to (1) generate sufficient revenue to cover the full costs of
             their operations and (2) operate on a break-even basis over time—that is,
             not make a profit nor incur a loss.

             The activity group generates revenue by billing customers at
             predetermined, fixed prices as it performs specifically agreed-upon work
             for those customers. The prices are to be based upon anticipated actual
             costs. DOD customers primarily use operations and maintenance
             appropriations to pay for the work. Payments from customers replenish the
             Air Force Working Capital Fund’s working capital, which is used to finance
             subsequent operations. The activity group is expected to operate within the
             revenue it generates. Conceptually, this provides an incentive to control
             costs and maximizes efficiency. It is essential that the activity group
             operates efficiently since every dollar spent inefficiently results in fewer
             funds available for other defense spending priorities.

             Developing accurate prices is challenging since the prices are developed
             about 2 years in advance of when the work is actually received and
             performed. In essence, the activity group’s budget development has to
             coincide with the development of its group’s customers’ budgets so that
             they both use the same set of assumptions. To develop prices, the activity
             group estimates (1) labor, material, overhead, and other costs based on
             anticipated demand for work as projected by customers, (2) total direct
             labor hours for each type of work to be performed, such as aircraft,
             engines, and repairable items, (3) the workforce’s productivity, and
             (4) savings due to productivity and other cost avoidance initiatives.




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Since the early 1990s, the depot maintenance activity group has undergone
downsizing, accomplished through annual reductions-in-force and “early
outs.” For instance, from fiscal years 1992 through 1999, the Air Force cut
the activity group’s workforce by 23 percent (7,000 workers). The activity
group was further affected by the work of the 1993 and 1995 Base
Realignment and Closure Commissions, which resulted in decisions to
close two of the Air Force’s five air logistics centers and the Aerospace
Guidance and Metrology Center.

DOD and the Air Force have also made several major policy and other
changes that affected the depot maintenance activity group’s costs, prices,
and work performed since the early 1990s. Air Force officials stated that
(1) both costs and the prices set to recover those costs have been
significantly affected by changes in the scope and mix of workload to be
performed and (2) the depot maintenance activity group’s costs have
increased due to the aging of the aircraft and engines. Table 1 shows these
changes have occurred throughout the 1990s.




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Table 1: Policy and Other Changes Affecting the Depot Maintenance Activity Group’s Prices, Costs, and Workload
Fiscal year           Policy and other changes
1992                  Establishment of the Defense Business Operations Fund required recovery of full costs in the activity group’s
                      prices.
1992 and 1993         The financing of repairable inventory items in the stock fund increased the activity group’s material costs
                      because the group did not pay for these items prior to this change.
1992 through 1999     In response to the declining force structure and the increasing amount of work that is being contracted out, the
                      Air Force reduced the number of activity group employees from about 31,000 in fiscal year 1992 to about
                      24,000 in fiscal year 1998. This affected the experience and skills of workers as well as the amount of work that
                      could be performed by the depots.
1993 to 1997          The Air Force converted its existing three level depot maintenance operations (organization, intermediate, and
                      depot) to two levels (organization and depot) for selected avionics and engine items. Since the engine work was
                      very material intensive, the average material cost per hour and the average customer price per hour both
                      increased.
1993 to present       The process of closing two air logistics centers and the Aerospace Guidance and Metrology Center and
                      transferring their work to other sources of repair reduced both the amount of work performed and the
                      productivity of the workforce at these activities.
1998                  The Air Force changed the method of pricing inventory items sold to customers, including the depot
                      maintenance activity group, which affected the group’s material costs.
1998 and 1999         About one-third of the group’s workload was scheduled to be competed or realigned, which affected the
                      location and the amount of work performed by the depots and resulted in a major hiring and training
                      requirement at the gaining activities.




Scope and                                  To determine what factors caused the prices to increase between fiscal
                                           year 1994 and fiscal year 1999, we obtained and analyzed budget
Methodology                                documents that provided information on cost factors, such as material
                                           costs, overhead costs, and salaries used in developing the prices. We
                                           discussed the reasons for the price increases with Air Force officials
                                           located at headquarters and the Air Force Materiel Command.

                                           To determine what factors caused the activity group to incur losses from
                                           fiscal year 1994 through fiscal year 1998, we obtained and analyzed budget
                                           documents and accounting information that provided information on
                                           budgeted and actual direct costs, overhead costs, workload expressed in
                                           direct labor hours (DLH), and productivity. When variances occurred
                                           between budgeted and actual reported information, we met with
                                           responsible budgeting and accounting officials to ascertain why there were
                                           differences and how the differences resulted in losses. To determine how
                                           the Air Force recovered the activity group’s reported losses, we obtained
                                           budget and accounting information on the amount of the losses and



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                         analyzed the methods used by the Air Force to finance those losses. We
                         discussed the different methods for recovering losses with Air Force
                         officials located at headquarters and the Air Force Materiel Command to
                         determine why they used several different methods.

                         We did not verify the accuracy of the accounting and budget information
                         used in the tables and charts in this report, all of which was provided by the
                         Air Force in then-year dollars. We are continuing our work and will report
                         separately on the Air Force’s ability to develop accurate estimates of
                         workload, material costs, and anticipated savings that were used in
                         developing depot maintenance prices.

                         We performed our work at the headquarters, Office of the Under Secretary
                         of Defense (Comptroller) and the Office of the Secretary of the Air Force,
                         Washington, D.C.; Air Force Materiel Command, Dayton, Ohio; the
                         Oklahoma City Air Logistics Center, Tinker Air Force Base, Oklahoma; the
                         Ogden Air Logistics Center, Hill Air Force Base, Utah; the San Antonio Air
                         Logistics Center, Kelly Air Force Base, Texas; the Sacramento Air Logistics
                         Center, McClellan Air Force Base, California; the Warner Robins Air
                         Logistics Center, Robins Air Force Base, Georgia; and the Defense Finance
                         and Accounting Service, Arlington, Virginia.

                         Our work was performed from May 1999 through October 1999 in
                         accordance with generally accepted government auditing standards. We
                         requested comments on a draft of this report from the Secretary of the Air
                         Force or his designee. On November 10, 1999, the Depot Maintenance
                         Program Manager provided us with oral comments. These comments are
                         discussed in the “Agency Comments” section of this report.



Factors Causing Prices   The depot maintenance activity group’s composite sales price4 increased
                         from $92.60 per DLH in fiscal year 1994 to $128.43 per DLH in fiscal year
to Increase              1999, an increase of about 39 percent.5 As shown in table 2 and discussed
                         below, almost all of this price increase can be attributed to three factors:
                         (1) direct material costs per DLH increased, (2) workload declined more


                         4
                         The composite sales price is the average price that customers must pay for a DLH of work.
                         5
                          The fiscal year 1994 information is in then-year dollars. If the fiscal year 1994 price is
                         converted to fiscal year 1999 dollars, it would be $106.58 per DLH. This would reduce the
                         increase to 20.5 percent.




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                             rapidly than overhead costs and, as a result, more overhead costs had to be
                             allocated to each DLH of work accomplished, and (3) the average cost of
                             civilian labor increased.



                             Table 2: Primary Reasons for the Air Force Depot Maintenance Activity Group’s
                             Fiscal Years 1994 and 1999 Sales Price Increase
                                                                                            Increase in the           Percent of
                             Reason                                                          price per DLH                 total
                             Direct material cost per DLH increased                                   $14.28                    39.8
                             Workload declined faster than overhead                                  $13.01a                    36.3
                             costs
                             Average cost of civilian labor increased                                  $7.76                    21.7
                             Other                                                                      $.78                     2.2
                             Total                                                                    $35.83                   100.0


                             a
                              The actual increase was $16.04 per hour, but $3.03 is not included because it resulted from an
                             increase in the average cost of civilian labor (which is a separate reason).




Direct Material Costs Have   Our analysis showed that the depot maintenance activity group’s budgeted
Increased                    direct material costs have declined much less than its budgeted workload.
                             Specifically, the activity group’s workload (expressed in DLHs) declined
                             nearly 35 percent between fiscal year 1994 and fiscal year 1999 due to
                             reductions in the Air Force’s force structure, along with other factors such
                             as the increased use of contractors. However, its direct material costs
                             declined less than 4 percent. As a result and as shown in table 3, direct
                             material costs per DLH increased $14.28, about 48 percent.




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Table 3: Budgeted Direct Material Costs per DLH for Fiscal Year 1994 and Fiscal Year
1999
                                            Fiscal year                   Change
Description                                    1994       1999        Amount          Percent
Direct material costs (in millions)        $1,029.7     $992.2        $(37.50)            (3.6)
DLHs (in millions)                           34.421     22.451         (11.97)           (34.8)
Direct material costs/DLH                    $29.91     $44.19          $14.28            47.7



Air Force depot maintenance officials stated that the increase in budgeted
direct material costs per DLH can be attributed to (1) higher material costs
and (2) increased material usage. Further, they stated that there is more
than one underlying cause for both of these factors. Part of the cost
increase can be attributed to inflation. Most of it, however, is attributable to
the fact that, in 1998, the Air Force supply management activity group
began charging specific customers the full cost of replacing condemned
inventory items (broken items that cost more to fix than to replace). In the
past, these costs were spread evenly to all customers. According to
Air Force officials, the net effect of this change was that some costs shifted
from other supply management activity group customers, such as Air Force
units, to the depot maintenance activity group.

Air Force depot maintenance officials also stated that material usage has
increased because (1) the workload mix now includes more work that has
relatively high material costs6 and (2) factors such as the aging of the
aircraft and engine inventory is causing them to replace more component
parts when repairs are accomplished. However, these depot maintenance
officials acknowledge that they (1) do not yet fully understand the effect of
the various factors that have affected their material costs in recent years
and (2) need to develop a better understanding of these factors if they are
to effectively manage their material costs. They also said that the Air Force
is making a concerted effort to develop this better understanding.




6
 For example, engine work, which has higher material costs than most workloads, increased
from 5.6 percent of the budgeted total in fiscal year 1994 to 12.5 percent in fiscal year 1999.




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Workload Decline Has       Reductions in the Air Force’s force structure, along with other factors such
Outpaced Overhead          as increased use of contractors, have reduced the amount of work
                           accomplished by the depot maintenance activity group’s depots. However,
Reduction
                           the depots’ overhead costs have not decreased proportionately to the
                           decline in the workload. As a result, the depots have had to allocate more
                           overhead costs to each DLH of work they accomplished. Specifically, as
                           summarized in table 4, the need to allocate overhead costs over a steadily
                           declining workload base has caused the amount of budgeted overhead
                           costs allocated to each budgeted DLH of work accomplished to increase
                           from $33.38 in fiscal year 1994 to $49.42 in fiscal year 1999, an increase of
                           about 48 percent.



                           Table 4: Budgeted Overhead Cost per DLH for Fiscal Year 1994 and Fiscal Year 1999
                                                                                           Change
                                                            Fiscal year Fiscal year
                           Description                            1994        1999      Amount      Percent
                           Overhead costs (in millions)       $1,149.1     $1,109.5     $(39.60)       (3.4)
                           DLHs (in millions)                   34.421      22.451       (11.97)      (34.8)
                           Overhead cost/DLH                    $33.38      $49.42       $16.04         48.1



                           According to Air Force depot maintenance officials, prices in general and
                           overhead cost in particular should decline after July 2001, when the
                           Air Force expects to finish closing two depots and transferring their
                           workload to other depots and contractors.


Average Cost of Civilian   An increase in the average cost of civilian labor increased the depot
Labor Has Increased        maintenance activity group’s prices by $7.76 per DLH for fiscal year 1994
                           through fiscal year 1999, about $3.03 for overhead labor and $4.73 for direct
                           labor. This increase was due to higher costs for both salaries and benefits.
                           Specifically, as shown in table 5,

                           • budget estimates for the average annual cost of employee compensation
                             (for basic salary and such variable costs as holiday and overtime pay)
                             increased by $5,752 per work year per employee, 15.5 percent over
                             5 years and




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                          • budget estimates for the average annual cost of employee benefits
                            (employer contributions for such things as health and life insurance)
                            increased by $2,147, or 29.1 percent over 5 years.



                          Table 5: Average Budgeted Cost of Civilian Labor for Fiscal Year 1994 and Fiscal
                          Year 1999
                                                                                            Change
                                                           Fiscal year   Fiscal year     Amount       Percent
                          Description                            1994          1999
                          Average employee                    $37,175       $42,927        $5,752        15.5
                          compensation
                          Average employee benefits            $7,375        $9,522        $2,147        29.1
                          Average compensation and            $44,550       $52,449        $7,899        17.7
                          benefits




Factors Contributing to   The Air Force depot maintenance activity group reported that it lost about
                          $623 million from fiscal years 1994 through 1998. Although many factors
the Activity Group’s      contributed to these financial losses, our analysis indicates that they
Financial Losses          occurred primarily because (1) the activity group did not accomplish as
                          much work as expected (budgeted) and was, therefore, unable to fully
                          recover its fixed overhead costs, (2) material costs were higher than budget
                          estimates, (3) prices were based on anticipated savings that were
                          subsequently determined by the Air Force to be overly optimistic, and
                          (4) the activity group incurred losses on its contract repair operations
                          during fiscal years 1996, 1997, and 1998.




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Projected Operating Results   DOD policy requires that the depot maintenance activity group operate on
Have Consistently Been        a break-even basis over time. However, from fiscal year 1994 through fiscal
                              year 1998, the activity group incurred losses every year. The activity group
Overly Optimistic
                              did not achieve its goal of operating on a break-even basis during this
                              period chiefly because it consistently developed overly optimistic
                              estimates for the activity group’s net operating results. For example, the
                              activity group was budgeted to earn a profit of about $200.1 million in fiscal
                              year 1998.7 However, instead of making a profit, the activity group reported
                              that it lost about $35 million during the year. Figure 1 shows the activity
                              group’s reported net operating results for fiscal years 1994 through 1998.




                              7
                              This budget was submitted to the Congress in February 1997.




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                             Figure 1: Air Force Depot Maintenance Activity Group’s Reported Actual Net
                             Operating Results for Fiscal Years 1994 Through 1998
                                       Dollars in millions
                                 $0


                                                                                  ($35)
                             ($100)
                                                       ($86)   ($78)

                             ($200)
                                         ($188)

                                                                         ($236)
                             ($300)



                             ($400)



                             ($500)



                             ($600)

                                                                                          ($623)
                             ($700)

                                        1994          1995     1996      1997     1998    94-98

                                        Fiscal year




Lower Than Budgeted          The Air Force depot maintenance activity group lost about $374 million
Production Levels            from fiscal years 1994 through 1998 because its workers accomplished
                             fewer DLHs of work than budgeted and because this, in turn, prevented it
Prevented Full Recovery of
                             from fully recovering its overhead costs. Air Force depot maintenance
Overhead Costs               officials stated the following.

                             • Overhead costs for such things as the salaries of administrative
                               personnel are generally fixed costs in the year of execution and
                               therefore do not vary significantly with the amount of work
                               accomplished during the year.
                             • When prices are developed approximately 2 years in advance of actual
                               work being accomplished, overhead costs are allocated on a prorated
                               share to each DLH of work expected to be accomplished in the year of
                               execution (i.e., in essence, each hour of work they accomplish pays for a
                               certain amount of overhead costs). When workload does not
                               materialize, regardless of the reason, DOD’s price stabilization policy



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   prohibits the activity group from increasing prices to make up for the
   shortfall.

Figure 2 shows that the number of budgeted DLHs declined from
34.4 million in fiscal year 1994 to 25.3 million in fiscal year 1998—a
9.1 million (26 percent) DLH reduction. Even though the Air Force reduced
the budgeted DLHs each year from fiscal year 1994 through fiscal year
1998, our analysis showed that the amount of work actually accomplished
during this 5 year period was still 10.1 million DLHs less than the budgeted
amount. Figure 2 shows the budgeted and actual DLHs for the 5-year
period.




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                            Figure 2: Depot Maintenance Activity Group’s Budgeted and Actual Production for
                            Fiscal Years 1994 Through 1998
                                       Hours in thousands
                            35,000
                                       34,421

                                                         32,517
                                                                            31,543
                                               30,252
                            30,000                                 29,585
                                                                                     29,022
                                                                                              28,297
                                                                                                       27,075
                                                                                                                         26,094
                                                                                                                25,317
                            25,000




                            20,000

                                        1994                1995             1996             1997                 1998

                                        Fiscal year


                                                Budget

                                                Actual




Activity Group Had Higher   The activity group’s reported actual material cost per DLH was
Than Budgeted Material      $16.61, about 38 percent higher in fiscal year 1998 than the previous fiscal
                            year. Further, as shown in figure 3: (1) in fiscal year 1998, the reported
Costs
                            actual material cost per DLH was $12.40, about 26 percent higher than the
                            budgeted amount and (2) although the Air Force increased the budget
                            estimate for material cost per DLH by $5.96 in fiscal year 1999, the reported
                            actual costs have been even higher.8 According to Air Force officials, these
                            increases were driven by a number of changes in the Air Force’s pricing
                            policy for depot-level repairables in order to more accurately distribute
                            costs to customers. The changes had the net effect of distributing a larger
                            share of material cost to depot maintenance and a smaller share to other
                            Air Force activities.


                            8
                             Actual fiscal year 1999 data are a straight-line projection of actual data for the first
                            10 months.




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Figure 3: Air Force Depot Maintenance Activity Group’s Budgeted and Reported
Actual Material Costs per DLH for Fiscal Years 1997 Through 1999
$65 Per DLH

                                                      $60.85
$60                              $60.23



$55
                                             $53.79


$50
                        $47.83

$45
               $43.62
      $42.57

$40


$35


$30


       1997               1998               1999
      Fiscal year

               Budget

               Actual


The higher than budgeted material cost per DLH caused the activity group’s
fiscal year 1998 material costs to be $324 million higher than budget
estimates.9 However, material costs per DLH of work accomplished vary
significantly from one workload to another, and a determination of the
effect of these higher material costs on the activity group’s financial
operating results would require a detailed analysis of individual workloads.

Recognizing that this is an area that needs more management attention, the
Air Force Materiel Command is beginning to implement metrics to develop
a better understanding of why material costs are increasing and how the
Command can better control and reduce material costs. This is a good step



9
 Reported actual material costs were $360.8 million higher than the budgeted amount, but
part of the difference was due to higher than budgeted production.




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                             toward ensuring that decisionmakers have the information they need to
                             manage the activity group as a business operation.


Anticipated Budget Savings   Another major contributor to the activity group’s financial losses has been
Did Not Materialize          its failure to achieve cost reduction and productivity improvement goals
                             that were incorporated into budget estimates. We could not determine how
                             much the activity group actually saved on individual initiatives because
                             activity group managers do not track and document actual savings.10
                             However, a comparison of initial budget estimates for savings (which are
                             used to develop prices) and revised budget estimates provides a good
                             indication that the savings are not being achieved. Specifically, as shown in
                             figure 4, in recent years, the initial budget estimate for savings has
                             repeatedly been reduced in the revised budget estimate, which is
                             developed the following year based on updated information.




                             10
                              Our report, entitled Air Force Depot Maintenance: Management Changes Would Improve
                             Implementation of Reform Initiatives (GAO/NSIAD-99-63, June 25, 1999), discussed that
                             the Air Force does not have a system for tracking savings.




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                             Figure 4: Comparison of Initial and Revised Budget Estimates for the Air Force
                             Depot Maintenance Activity Group’s Savings for Fiscal Years 1996 Through 1998
                             $300   Dollars in millions



                             $250                                                             $241



                             $200


                                       $151
                             $150



                             $100
                                                                                                      $79
                                                 $65
                                                             $55
                              $50                                             $35

                                                                                    $10
                                                                   $4
                               $0

                                       1996                 1997             1998             96-98


                                       Fiscal year

                                                Original budget

                                                Revised budget




Contract Operations Have     As shown in figure 5, the activity group’s contract operations reported a net
Lost Money in Recent Years   operating loss of about $210 million during fiscal years 1994 through 1998, a
                             profit of about $21 million during the first 2 fiscal years, and a loss of
                             $231 million during the last 3 fiscal years.




                             Page 17                                    GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
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Figure 5: Air Force Depot Maintenance Activity Group’s Reported Actual Net
Operating Results From Its Contract Operations for Fiscal Years 1994 Through 1998
     $40 Millions of dollars
                           $20.1
     $20      $1.0
                                   -$36.0      -$73.3   -$121.6
      $0

 -$20

 -$40

 -$60

 -$80


-$100

-$120

-$140
             1994          1995     1996         1997     1998

             Fiscal year


Although figure 5 indicates that the activity group’s financial performance
on its contract operations has declined steadily since fiscal year 1995, the
results are distorted by a $98.8 million “accounting” loss in fiscal year 1998.
This loss occurred because the Air Force changed its accounting policy on
valuing inventory located at contractor plants and inventory in transit from
the contractors to the Air Force.11 Since this loss was due to the revaluation
of inventory and not due to actual losses resulting from operations, the Air
Force, with Office of the Under Secretary of Defense (Comptroller)
approval, did not recover this loss in its prices. Without this change in
accounting policy, the reported fiscal year 1998 loss would have been
$22.8 million rather than $121.6 million.



11
 Prior to 1998 (1) the activity group paid the full (standard) price for repairable items
provided to contractors, (2) items at contractor plants were valued at standard prices, and
(3) the activity group was credited for the carcass value (standard price less exchange
price) when broken items were returned to supply. Under the new policy (1) the activity
group pays the exchange price (standard price less carcass value) for items provided to
contractors, (2) the value of items at contractor plants is based on exchange prices, and
(3) the activity group receives no credit when contractors return broken items to supply.




Page 18                                     GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
                              B-283840




                              Most of the activity group’s other contract losses were caused by problems
                              related to the management and control of government-furnished material
                              provided to contractors. For example, one air logistics center lost about
                              $18.8 million on a single contract because of numerous material-related
                              control problems, including (1) Air Force records showed that more
                              material was shipped to a contractor than was received by the contractor
                              and (2) material that was supposed to be on hand at the contractor’s
                              facilities was not found.



Air Force Has Tried           Over the last 5 years, the Air Force has tried four different methods to
                              recover the activity group’s losses. For fiscal years 1995 and 1996, prices
Different Methods to          the group charged individual customers for work were increased to recover
Recover Activity Group        losses. For fiscal year 1997, rather than increase prices, the Air Force
                              requested an appropriation to recover losses but the request was denied by
Losses                        the Congress. In fiscal years 1998 and 1999, the Air Force used two
                              different methods to recover the activity group’s losses. First, the Air Force
                              separated approved customer prices into two pieces: an amount charged
                              individual customers for work performed in the current year and an
                              amount used to recover $310 million in prior year losses. Under the second
                              method, the activity group recovered or plans to recover $313.4 million in
                              losses in the fiscal year they occurred. Air Force officials told us that the
                              activity group will have about $30.5 million in accumulated operating
                              losses at the end of fiscal year 1999. These losses occurred during fiscal
                              year 1999 (primarily in the last quarter) and the Air Force plans to recover
                              them during fiscal year 2000.


Fiscal Years 1995 and 1996    DOD policy12 requires depot maintenance activities, as well as other
Prices Increased to Recover   working capital fund activities, to operate on a break-even basis over time.
                              To do this, working capital funds are to establish prices that would allow
Losses
                              them to recover from their customers the expected costs of operations, as
                              well as any prior years’ losses. In accordance with this policy, the Air Force
                              increased the activity group’s fiscal years 1995 and 1996 customer prices in
                              an attempt to recover prior year losses. However, even though the prices
                              were increased, the activity group reported losses of about $86 million and
                              $78 million in fiscal years 1995 and 1996, respectively.


                              12
                               DOD’s Financial Management Regulation, Volume 11B, Reimbursable Operations,
                              Policy and Procedures—Defense Business Operations Fund, Chapter 50, page 50-2.




                              Page 19                           GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
                              B-283840




Appropriation of $194.5       Although the general practice has been to recover losses through
Million Requested in Fiscal   increasing the prices charged customers, DOD policy also allows losses to
                              occasionally be recovered by a direct appropriation. In its fiscal year 1997
Year 1997 to Recover Losses
                              budget submission to the Congress, rather than increasing prices, the
                              Air Force requested that $194.5 million be appropriated to its Operations
                              and Maintenance account to specifically recover the activity group’s
                              accumulated operating losses. The Operations and Maintenance funds
                              were then to be transferred (called a pass through) to the activity group.

                              In its budget submission to the Congress, the Air Force stated that the
                              requested appropriation was necessary to reduce the impact of external
                              events that were beyond its control on the activity group’s prices. The
                              Air Force stated that the DOD force structure reduction initiatives caused
                              workforce turmoil (unexpected workload losses, skilled labor imbalances,
                              and multiple job changes) that undercut budgeted productivity and
                              efficiency goals. The Air Force further stated that the $194.5 million pass
                              through was essential to the liquidity of its working capital fund and
                              protected customers from unacceptable future price increases.

                              The Congress denied the Air Force’s request for the pass through. In
                              reviewing the request, the House Appropriations Committee stated that
                              DOD has had a policy of recovering prior year operational losses through
                              adjustments (increases) in prices. The Committee further stated that it
                              generally supported the policy of recovering losses through prices, and
                              since DOD requested a pass through to recover losses, the Committee was
                              concerned that DOD may be making a significant shift in policy. The
                              Congress subsequently reduced the Air Force’s fiscal year 1997 budget
                              submission by the $194.5 million requested.


Prior Year Losses Recovered   Activity group customer prices that were approved by DOD for fiscal years
by Separating Fiscal Years    1998 and 1999 and submitted to the Congress in the Air Force’s budget
                              justification books included an amount to recover $310 million in prior year
1998 and 1999 Prices Into
                              losses. According to Air Force officials and budget documents, these losses
Two Pieces                    were related to the closing of two depot maintenance activities
                              (San Antonio and Sacramento) and force structure reductions. To ensure
                              that the prior year losses were recovered, the Air Force separated the
                              group’s approved prices into two pieces. The first piece was the amount or
                              price the group charged customers for current year work. The second
                              piece—the difference between the approved price and the actual price
                              charged customers—was the amount to be used to recover the $310 million
                              in prior year losses in fiscal years 1998 and 1999.


                              Page 20                        GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
                            B-283840




                            The funds representing the difference between the approved prices and the
                            prices actually charged customers—$176 million to be recovered in fiscal
                            year 1998 and $134 million to be recovered in fiscal year 1999—were
                            accounted for at Air Force headquarters and have been or will be provided
                            to the depot maintenance activity group. The Air Force sent project orders
                            to the activity group to recover these losses. By using this method, the Air
                            Force was able to help ensure that the activity group received or will
                            receive the funds to recover the prior year losses.


Losses Recovered in the     For many years, DOD has had a policy of recovering prior year losses
Fiscal Year They Occurred   through increased customer prices for future work. Starting in fiscal year
                            1998, DOD changed this policy for its depot maintenance activities. DOD
                            now requires unbudgeted losses to be recovered in the year they occur by
                            adding a surcharge to individual customer’s bills. An unbudgeted loss is the
                            difference between a depot maintenance activity’s net operating results
                            that were estimated in its budget and the actual net operating results
                            experienced in the current year.

                            DOD changed its policy because it believed this would (1) encourage
                            depots to initiate cost controls more rapidly, (2) provide the right
                            incentives to set prices correctly, and (3) eliminate the routine use of
                            advance billing to cover execution losses.13 This policy helps to control
                            costs because it puts pressure on the Air Force to ensure that the depot
                            maintenance activity group sets prices correctly.

                            The Air Force followed DOD’s policy change in fiscal years 1998 and 1999,
                            and as a result, its depot maintenance activity group collected or plans to
                            collect $313.4 million from customers to recover unbudgeted losses during
                            these 2 fiscal years—$182.6 million and $130.8 million in fiscal years 1998
                            and 1999, respectively. However, rather than adding a surcharge to
                            customers’ bills as required by DOD’s new policy, the Air Force used
                            project orders to specifically recover the losses. Customers (major
                            commands) sent project orders to the depot maintenance activity group
                            which then, in turn, billed for the amount on the orders to recover the
                            losses.



                            13
                             Since 1993, the defense working capital funds have experienced a cash shortage and have
                            had to advance bill customers for work not yet performed in order to ensure that the funds’
                            cash balances remained positive.




                            Page 21                              GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
                  B-283840




                  To help Air Force customers pay the activity group their portion of the
                  losses related to current year work orders, the Air Force transferred
                  $134.6 million in fiscal year 1998 and $80.5 million in fiscal year 1999 from
                  its Procurement, Military Personnel and/or Research, Development, Test
                  and Evaluation appropriations to Air Force customers’ Operations and
                  Maintenance appropriation. According to Air Force officials, the remaining
                  $98.3 million in unbudgeted losses was related to prior year orders, the
                  work for which was performed in the current year. To pay the activity
                  group for these losses, Air Force customers used prior year funds that
                  financed the orders that were still available for obligation.



Conclusions       Over the past 5 years, the Air Force depot maintenance activity group has
                  not been able to meet its financial goal of operating on a break-even basis.
                  Even though the activity group increased its prices 39 percent, the activity
                  group reported losses of $623 million. These losses primarily occurred
                  because the Air Force did not develop accurate estimates of its expected
                  material costs, direct labor hours to be performed, and anticipated savings
                  that were used in developing prices. Beginning in fiscal year 1998, the
                  Air Force began recovering losses in the year that they occurred. As a
                  result, the activity group will be closer to breaking even at the end of fiscal
                  year 1999 than it has in the past 5 years.

                  The Air Force is also beginning to implement management metrics to
                  develop a better understanding of why material costs are increasing and
                  how they can be better controlled. While this is a good step toward
                  ensuring that decisionmakers have the information they need to manage
                  the activity group as a business operation, it will be important for the group
                  to also develop metrics for other key factors such as workload, overhead
                  costs, and anticipated savings. Our subsequent review will assess the
                  effectiveness of existing metrics and provide additional perspective on the
                  need for other measures.



Agency Comments   Air Force officials provided comments on previous briefings on the results
                  of our work. These comments were incorporated in this report as
                  appropriate. In providing oral comments on this report, Air Force officials
                  agreed with our findings and conclusions.




                  Page 22                         GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
B-283840




We are sending copies of this report to Representative Solomon P. Ortiz,
Ranking Minority Member, Subcommittee on Military Readiness, House
Committee on Armed Services; Senator John Warner, Chairman, and
Senator Carl Levin, Ranking Minority Member, Senate Committee on
Armed Services; Senator Ted Stevens, Chairman, and Senator Daniel K.
Inouye, Ranking Minority Member, Subcommittee on Defense, Senate
Committee on Appropriations; and Representative Jerry Lewis, Chairman,
and Representative John P. Murtha, Ranking Minority Member,
Subcommittee on Defense, House Committee on Appropriations. We are
also sending copies of this report to the Honorable William S. Cohen,
Secretary of Defense, and the Honorable F. Whitten Peters, Secretary of the
Air Force. Copies will also be made available to others upon request. If you
have any questions about this report, please call Mr. Greg Pugnetti,
Assistant Director, at (202) 512-6240. Other key contributors to this report
are listed in appendix I.

Sincerely yours,




Jack L. Brock, Jr.
Director, Governmentwide and Defense Information Systems
Accounting and Information Management Division




David R. Warren
Director, Defense Management Issues
National Security and International Affairs Division




Page 23                        GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
Appendix I

GAO Staff Acknowledgements                                                                                  Appendx
                                                                                                                  Ii




                              Cristina Chaplain, Karl J. Gustafson, William A. Hill, Ron L. Tobias, and
                              Eddie W. Uyekawa made key contributions to this report.




(511663 and 709418)   Leter   Page 24                        GAO/AIMD/NSIAD-00-38 Air Force Depot Maintenance
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