Contract Pricing: Implementation of Cost Estimating Regulations

Published by the Government Accountability Office on 1990-09-28.

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

September   1990
                     CONTRACT PRICING
                     Implementation of
                     Cost Estimating

                         -----           _L-_
 GAO,‘NSLAD-90-290                              :
                    United States
GAO                 General Accounting  Office
                    Washington, D.C. ‘20648

                    National Security and
                    International  Affairs Division


                    September 28, 1990

                     The Honorable John Conyers, Jr.
                     Chairman, Legislation and
                       National Security Subcommittee
                     Committee on Government Operations
                     House of Representatives

                     Dear Mr. Chairman:

                     As you requested, we reviewed contract auditors’ and administrative
                     contracting officers’ compliance with Department of Defense (DOD) regu-
                     lations for reviewing contractor estimating systems. Our objectives were
                     to determine whether (1) DOD estimating system reviews were conducted
                     as joint contract audit and contract administration team efforts as
                     required, (2) estimating system reports prepared by Defense Contract
                     Audit Agency (DCAA)personnel contained appropriate recommendations
                     for disapproving all or parts of contractor systems as called for by the
                     DOD regulations, and (3) DOD administrative contracting officers followed
                     the procedures prescribed for correcting identified deficiencies.

                          revised its procurement regulations in March 1988 to establish more
Results in Brief     DOD
                     stringent requirements governing contractor estimating systems, and
                     KAA has devoted significantly more resources to reviewing contractor
                     cost estimating systems. Although DOD has revised its regulations, con-
                     tract auditors and administrative contracting officers have not fully
                     complied with them. For example:

                   . Contract administration personnel did not participate as a team member
                     in 10 of the 16 reviews we examined even though their participation is
                     essential in evaluating certain costs generated by contractor estimating
                     systems and included in contract proposals.
                   . Only 1 of the 16 KXXAreports that we examined recommended disap-
                     proval of all or part of a contractor’s system, although all 16 reports
                     identified potentially significant deficiencies.
                   . Administrative contracting officers generally did not follow the regula-
                     tory process for correcting identified estimating deficiencies.

                     When DOD awards contracts noncompetitively, it lacks the economic
Background           safeguards normally found in the competitive marketplace and must

                     Page 1                                       GAO/NSIAD90.290   Contract   Pricing

                         contract prices because the contractors had not evaluated the subcon-
                         tracts as required by procurement regulations.
                       . In January 1988, we reported that the prices of 17 noncompetitive DOD
                         contracts were overstated by $21 million because contractor labor esti-
                         mates had not considered actual labor experience on prior contracts.”
                         Rather, contractors’ proposed labor estimates were based on judgment
                         and lacked verifiable support. The actual labor cost incurred on the 17
                         contracts was about 22 percent below the estimates proposed by the
                       l In January 1988, we also reported that contractors had proposed about
                         $135 million (on eight noncompetitive contracts) for scrap, raw mater-
                         ials, engineering changes, and other items. The estimates were based on
                         rates, percentage factors, and cost estimating relationships without veri-
                         fiable data because contractors had not accounted for such costs. How.
                         ever, DOD contracting officers negotiated $95 million in the contract

                           Our prior work and hearings by the House Government Operations’ Leg-
                           islation and National Security Subcommittee had revealed a number of
                           problems with DOD’S oversight of contractor estimating systems: (1) esti-
                           mating deficiencies remained uncorrected for long periods; (2) the ele-
                           ments of an acceptable estimating system were not well defined; (3)
                           responsibility for resolving deficiencies was not clear; and (4) contract
                           audit and administration team reviews of contractor estimating systems
                           generally had not been conducted since the early 1970s. The March 1988
                           revision to DOD’s regulations was designed to overcome these

                           According to DOD’S revised regulations, contractor estimating systems
Revised Regulations        should consistently produce well-supported proposals that are accept-
Provide for                able to the government as a basis for negotiating fair and reasonable
Identifying and            contract prices. To ensure that a contractor meets this criterion, the reg-
                           ulations require that the DCAAcontract auditor lead a team effort, along
Resolving Estimating       with the contract administration office, to regularly review (generally
System Deficiencies        every 3 years) the adequacy of each contractor’s estimating system.
                           DCAAshould then document the review results in a report to the adminis-
                           trative contracting officer. If the review finds “significant” estimating

                           3Cmtract     Pricing: Defense Contractor   Cost Estimatii   Systems (GAO/NSIAD-88-7,   Jan. 5. 1988)

                           Page 3                                                             GAO,‘NSL4DOO-290    Contract   Pricing

                        For 6 of the 16 DCA~Z estimating system reports we reviewed, KG and
                        contract administration personnel had made team reviews. However, in
                        the other 10 cases, contract administration personnel did not participate
                        as team members in reviewing contractor estimating policies, proce-
                        dures, and practices. We found essentially the same situation in our
                         1985 review.

                        Although EAA has significantly increased the time it devotes to
System Review           reviewing contractor estimating systems (from 37,566 hours in 1986 to
Reports Did Not         114,lZ 1 hours in 1989) its system review reports to administrative con-
Identify the            tracting officers have not fully met the requirements of the revised reg-
                        ulations. While all 16 estimating system reports that we reviewed
Significance of         identified potentially significant deficiencies, only 1 report recom-
Deficiencies or         mended disapproval of all or a part of the contractor’s estimating
                        system as required.
Disapproval             When we brought this matter to the attention of the DCAAauditors
                        responsible for conducting the estimating system reviews, they told us
                        that, at the time they had prepared the reports, they were not aware of
                        the regulatory requirement to recommend system disapprovals. Rather,
                        they had followed the DCAAaudit manual, which did not contain gui-
                        dance on disapproval recommendations. DCU notified its auditors of the
                        estimating system regulations in May 1988 but did not provide guidance
                        in its audit manual until July 1989. At that time, the manual was revised
                        to state that deficiencies should be identified as minor or significant and
                        that, if significant, the auditors should recommend system disapproval
                        in whole or in part.

                         Administrative contracting officers frequently did not follow the proce-
Administrative           dures established to ensure the timely correction of identified deficien-
Contracting Officers     cies in contractor estimating systems. For example, administrative
Generally Did Not        contracting officers had not provided 10 of the 16 reports we reviewed
                         to the contractors for their comments. This omission short-circuited the
Follow Procedures for    regulatory process that is aimed at placing administrative contracting
Correcting               officers in positions to determine the adequacy of contractor systems. Of
Deficiencies             the 10 reports, 3 were provided to the contractors after we visited the
                         contract administration offices.

                         Also, for 12 of the 16 reports, administrative contracting officers had
                         not determined. as required by the regulations, whether (1) the esti-
                         mating systems contained deficiencies that needed correction, (2) any

                         Page 6                                        GAO/‘NSuD9o-29O   Contract   F’hine

Please contact me at (202) 275-8400 if you or your staff have any ques-
tions concerning this report. Other major contributors to this report are
listed in appendix II.

Sincerely yours,

Director, Research, Development, Acquisition,
  and Procurement Issues

 Page 7                                         GAO/NSlADOO.2SO   Contract   Pride@
Page 9   GAO/NSIABBMBO   Contract   Pricing

kzir        Contributors to This Report

                         David E. Cooper, Assistant Director
National Security and
International Affairs
Division, Washington,

                         George C. Burdette, Regional Assignment Manager
Atlanta Regional         Gene M. Barnes, Evaluator
Office                   Magdalene Harris, Evaluator

                         Paul M. Greeley, Evaluator-in-Charge
Boston Regional Office   Susie A. Pickens, Evaluator
                         Stephen J. Licari, Evaluator

(39665.9)                Page 11                                   GAO/NSlAJM@2BO   Contract   Prlchg

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Appendix I

Scow and Methodology

                 Using Defense Federal Acquisition Regulation Supplement 215.811 and
                 related DOD guidance on cost estimating system reviews as criteria. we
                 reviewed 16 estimating system reports, all of which were issued after
                 March 18, 1988, the effective date of DOD’S regulations. We also analyzed
                 related documents prepared by XAA and contract administrators and
                 interviewed DCXAand contract administration officials about their
                 system review activities and actions regarding the selected reports. The
                 16 reports we reviewed were judgmentally selected and addressed the
                 estimating systems of the following 16 defense contractors:

             9   E-Systems, Incorporated, St. Petersburg, Florida;
             .   General Dynamics Corporation, Groton, Connecticut;
             .   GTE Communication Systems Division, Needham, Massachusetts;
             .   GTE Strategic Systems Division, Westborough, Massachusetts;
             .   Harris Corporation, Melbourne, Florida;
             .   Hazeltine Corporation, Greenlawn, New York;
             l   Hercules, Incorporated, Clearwater, Florida;
             .   Honeywell, Incorporated, Clearwater, Florida;
             .   Raytheon Company, Equipment Division, Marlborough, Massachusetts;
             .   Raytheon Company, Submarine Signal Division, Portsmouth, Rhode
             0   Rockwell International Corporation, Duluth, Georgia;
             .   Lockheed Corporation, Nashua, New Hampshire;
             +   SC1Technology, Incorporated, Huntsville, Alabama;
             l   United Technologies Corporation, Hamilton Standard Aircraft Systems
                 and System Controls and Accessories, Windsor Locks, Connecticut;
             l   United Technologies Corporation, Hamilton Standard Space and Sea Sys-
                 tems, Windsor Locks, Connecticut; and
             l   United Technologies Corporation, Pratt & Whitney, West Palm Beach,

                 We made our review between January 1989 and July 1990 in accor-
                 dance with generally accepted government auditing standards.

                 Page 10                                       GAO/NSIAD90-290   Contract   Pricing
Appendix I                                                                                      10
Appendix II                                                                                     11
Major Contributors to
This Report


                        XAA       Defense Contract Audit Agency
                        DOD       Department of Defense
                        GAO       General Accounting Office

                        Page 8                                    GAO/NSUDgO-290 Contract   Pricing

              deficiencies were significant enough to warrant disapproving all or a
              portion of the systems, or (3) any contractor-proposed corrective actions
              were adequate to correct the deficiencies. At the completion of our
              review, 11 of the 12 reports contained one or more significant deficien-
              cies that had been uncorrected for at least 2 years.

              Administrative contracting officers had followed procedures for cor-
              recting identified estimating deficiencies in 4 of the 16 reports we
              reviewed. As a result, two contractors had corrected the deficiencies,
              and two contractors had their estimating systems disapproved.

              Our prior work has shown that millions of dollars could be saved if DOD
Conclusions   identified and promptly corrected inadequate contractor estimating sys-
              tems. We support DOD’S emphasis on contractor estimating systems and
              believe the revised regulations are an important step toward negotiating
              fair and reasonable prices. However, our sample of 16 DCAAreports has
              indicated that DOD’s efforts to identify and eliminate estimating system
              deficiencies have not been as successful as possible.

              Our scope and methodology are discussed in appendix I. As requested,
              we did not obtain written agency comments on this report. However, we
              discussed its contents with DOD officials and have included their com-
              ments where appropriate.

              Unless you publicly announce its contents earlier, we plan no further
              distribution of this report until 30 days from the date of this letter. At
              that time, we will send copies to the Secretary of Defense and the Direc-
              tors of the Defense Logistics Agency and m. We will also send copies
              to interested parties and make copies available to others upon request.

              Page 6                                        GAO/NSlAWXM90   Contract   Pricing

                              deficiencies,’ the report should recommend the disapproval of all or a
                              portion of the estimating system.

                              The regulations clearly assign responsibility for determining the ade-
                              quacy of contractor systems to the administrative contracting officer.
                              The regulations also provide the following detailed sequence of actions
                              that the administrative contracting officer should follow to ensure the
                              timely correction of estimating system deficiencies:

                      . After receiving LXXA’Sreport, the administrative contracting officer
                        should submit a copy to the contractor and request written agreement or
                        disagreement with the report’s findings and recommendations.
                      l After considering the contractor’s response and consulting with the DCAA
                        auditor, the administrative contracting officer should determine
                        whether (1) the estimating system contains deficiencies needing correc-
                        tion, (2) any deficiencies are significant and would result in the disap-
                        proval of all or a portion of the estimating system, or (3) any proposed
                        corrective actions are adequate.
                        The administrative contracting officer should then notify the contractor

                        of the determination and, if appropriate, the government’s intent to dis-
                        approve all or part of the system.

                               The auditor and administrative contracting officer are required to mon-
                               itor the contractor’s progress in correcting any deficiencies. If the con-
                               tractor fails to make adequate progress, the administrative contracting
                               officer must take whatever actions are necessary to ensure that the defi-
                               ciencies are corrected. Such actions include reducing or suspending pro-
                               gress payments and recommending that potential contracts not be
                               awarded to the contractor.

Many Estimating                expertise needed to analyze such things as the accuracy and reliability
System Reviews Were            of contractor estimates for manufacturing and engineering labor hours,
Not Conducted as               material quantities, scrap and rework costs, and various overhead costs.
                               The costs for such items represent a substantial portion of contractors’
Team Efforts                   proposals and can total millions of dollars.

                                ‘The regulations define a “s@ificant” estimating deficiency as a shortcoming that is likely to consist-
                                ently result in estimates that in total, or for a major cost element, do not constitute an acceptable
                                basis for negotiating faw and reasonable prices.

                                Page 4                                                         GAO/NS~90.290         Contract   Prlci~~~

                        rely largely on information produced by contractor cost estimating sys-
                        tems to establish contract prices. Therefore, sound estimating systems
                        that produce reliable contract proposals are fundamental to negotiating
                        fair and reasonable noncompetitive contract prices.

                        To ensure that such contract prices are fair and reasonable, DOD issued
                        revised regulations on contractor cost estimating systems in March
                        1988. The regulations, issued in response to the House Committee on
                        Government Operations’ and our recommendations, require certain
                        major contractors to establish and maintain adequate cost estimating
                        systems and to disclose their systems to DOD.

                        DOD’s revised regulations are contained in section 215.811 of the Defense
                        Supplement to the Federal Acquisition Regulation. According to the reg-
                        ulations, an “estimating system” encompasses all of a contractor’s poli-
                        cies, procedures, and practices for generating cost estimates based on
                        available information. It includes the organizational structure; estab-
                        lished lines of authority, duties, and responsibilities; internal controls
                        and managerial reviews; flow of work, coordination, and communica-
                        tion; and estimating methods and analyses, accumulation of historical
                        costs, and other data included in contract proposals.

                        Estimating system deficiencies can cause inflated contract prices. In sev-
Our Past Reviews        eral reviews conducted between 1986 and 1988, we found a number of
Found Problems With     weaknesses in the way contractors had estimated material, labor, and
Estimating Systems      other costs for noncompetitive contracts, such as the following:
and DOD Oversight   . In October 1985, we reported on a review of 87 subcontracts negotiated
                      under DOD prime contracts valued at $785 million1 We found that prime
                      contractors had been able to negotiate subcontract prices that were
                      $42 million (about 5 percent) below those included in prime contract
                      prices. The reductions resulted because contractors had not evaluated
                      subcontracts before prime contracts were awarded, as required by DOD
                      procurement regulations.
                    . In June 1987, we reported on an additional 28 subcontracts which had
                      been negotiated into DOD prime contracts for about $92 million.* Again,
                      we found that prime contractors had negotiated subcontract prices that
                      were about $10 million (about 11 percent) below those included in prime

                        ‘GAO Work at Defense Contractor Plants, statement of Frank C. Conahan before the Legislation and
                        Kational Security Subcommittee, House Committee on Government Operation (Ott 3, 1986).
                        *Contract pricing: Contractor Cost Estimating
                                                                    System (GAO/NSIAD-87-140, June 3,1987)

                        Page 2                                                     GA0/NSIAD80.280     Contract Priw