oversight

Government Contracting: Compensation of Defense Contractors' Working Capital Financing Costs

Published by the Government Accountability Office on 1990-01-31.

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 Defense, Committee on
                      Appropriations, U.S. Senate


January    1990
                      GOVERNMENT
                      CONTRACTING
                      -

                      C;omwnsation 01
                                                        a   l            n




                      Defeke Contractors’
                      Working Capital
                      fianc&g                          [ costs




                                            --     -
          HAD-90-33
GAO
                   United States
                   General Accounting    Office
                   Washington,   D.C. 20548

                   National Security and
                   International  Affairs Division

                   B-224639

                   January 31,1999

                   The Honorable Daniel K. Inouye
                   Chairman, Subcommittee on Defense
                   Committee on Appropriations
                   United States Senate

                   Dear Mr. Chairman:

                   As requested, we reviewed the Department of Defense’s (DOD) profit pol-
                   icy to determine whether it appropriately considers a contractor’s work-
                   ing capital costs by taking into account the important factors that affect
                   working capital.

                   DOD’s profit policy includes a provision to recognize the millions of dol-
                   lars defense contractors incur annually in financing working capital
                   costs on fixed-price contracts. Working capital costs consist of the con-
                   tractor’s work in process costs-material,      labor, and overhead-that
                   are not financed through progress payments’ or other payments. In
                   negotiating contract prices, DOD does not attempt to prepare an exact
                   calculation of such costs, but instead tries to give general recognition to
                   the contractor’s working capital costs under varying contract circum-
                   stances, financing policies, and economic environments. If DOD’S policy
                   does not appropriately consider a contractor’s working capital financing
                   costs, it could affect contract profits, either to the contractor’s or the
                   government’s disadvantage.


                          policy generally recognizes the important factors that affect con-
Results in Brief   DOD's
                   tractors’ working capital financing costs. Our analysis of a sample of
                   contracts showed that in the aggregate the policy resulted in approxi-
                   mately the right amount of these financing costs being included in the
                   profit objective. That is, the costs likely to be incurred during the life of
                   the contract were close to the amounts estimated by DOD. While this was
                   true in the aggregate, there were differences of 10 percent or more in
                   most of the individual contracts between DOD'S estimate and our esti-
                   mate of working capital costs. On individual contracts, therefore, if con-
                   tracting officers do not adjust for the specific circumstances of that
                   contract, too much or too little profit could be included in the contract
                   price.

                   ‘Progress payments aw used by DOD to finance a certain percentage of a contractor’s work-m
                   process on fixed-price contracts through monthly reimbursements of allowable costs incurred.



                   Page 1                                       GAO/NSIAB~OGB       Working Capital Financing Costs
             5224639




             Because working capital is just one element used in determining contrac-
             tor profit objectives, these adjustments for working capital financing
             costs would generally not be large in relation to the total contract price.
             In some of our sample cases, however, our analysis showed differences
             of close to $ I million in the contract price, comparing DOD’S estimate to
             ours. We believe that DOD contracting officers need to carefully consider
             whether adjustments are needed in working capital financing costs to
             more closely approximate cost actually incurred.


                   profit policy consists of a set of structured guidelines that are used
Background   DOD’s
             by its contracting officials to establish a profit objective for contract
             negotiating purposes. The working capital profit factor is one element
             included in the profit objective.

             DOD  revised its profit policy in October 1986. Before this revision, the
             policy only recognized contractors’ financing expenses implicitly as an
             undefined portion of the contract risk profit factor. The revised policy,
             for the first time, enables a contracting officer to include an explicit
             amount in the total profit objective for a contractor’s forecasted costs of
             financing working capital.

             DOD  developed a simplified calculation that negotiators can use to deter-
             mine the element representing the working capital profit factor to be
             included in the overall contract profit objective. This calculation consid-
             ers (1) the contractor’s estimated working capital costs (estimated total
             contract costs less progress payments), (2) the g-month Treasury rate,
             and (3) the contract length2 and the timing of delivery payments to con-
             tractors. In determining the overall working capital profit objective,
             DOD’s policy provides general guidance that calls for adjustments to be
             made for scheduled delivery payments” and other factors that would
             reduce contractor working capital requirements.

              Data on the negotiated profit objective for the working capital profit
              factor were not available when our review was initiated. However,
              according to DOD’S data, 2,015 negotiated fixed-price contracts were
              awarded in fiscal years 1985-87, which would likely be subject to the
              working capital profit factor in DOD’S profit policy.

              ‘The contract length factor represents the pencd of time that the contractor has a working cap&
              Lnvestment in the contract

              ‘Delivery payments corwst of the price for the items delivered less progress payments. The funds
              recewed as part of the debvery payment reduces the contractors’ financing requirements



              Page 2                                       GAO/NSlAlHO-33      Working Capital Financing Costs
                        B224639




                        We sent a questionnaire to contractors to collect data on expected work-
                        ing capital costs. Using this data, we estimated working capital costs on
                        these contracts and compared it to the working capital profit factor
                        derived from using the current profit policy. (See app. III for examples
                        of our computation of projected working capital financing costs.)

                        Our purpose was to evaluate the relationship between the amount of
                        working capital profit factor that would be established in a profit objec-
                        tive using DOD’S profit policy and the predicted working capital financ-
                        ing costs for a Sample of DOD COntraCtS.


                        In our study, we applied W D ’S current profit policy methodology to the
DOD’s Working           delivery payments and spending plan data obtained on contracts in our
Capital Profit Factor   sample. We concluded that W D ’S methodology, in total, would result in
Accurate Overall, but   about the same amount of financing cost that we estimated contractors
                        would incur. Therefore, in terms of generally recognizing the important
Not for Individual      factors that affect contractors’ working capital financing costs, the pol-
Contracts               icy achieves its goal. However, the impact on individual contracts
                        varied-our    analysis showed that DOD’s policy underestimated the
                        working capital financing costs on many contracts and overestimated
                        the working capital on many other contracts.

                        Our analyses of the relationship between the working capital profit
                        objective in DOD’S current policy and contractors’ expected financing
                        costs’are based on contracts that provided detailed data about the
                        expected timing of contract expenditures. Based on the contractors’
                        monthly unreimbursed costs, we estimated the total working capital
                        financing costs for these contracts to be about 1.4 percent of the total
                        contract costs. Applying DOD’s methodology to the contract data col-
                        lected indicated that profit objectives also would be about 1.4 percent of
                        the total contract costs in the aggregate.

                        We compared the profit objective and the financing costs on each con-
                        tract by subtracting the estimated working capital profit objective from
                        the predicted financing costs on a contract-by-contract basis. For
                        approximately 87 percent of the contracts, representing about 80 per-
                        cent of the projected dollar value, or $25 billion, inaccuracies of 10 per-
                        cent or more in working capital profit objectives would result under

                        ‘We used a progress paymrnt rate of 80 percent and an interest rate of 8 5 percent I” calculatmg
                        fmancmg costs We chose these rates because they were m effect at the tmw DOD reused ith pohcy
                        Future changes m the ptwgrcss payment rates and mterest rates would not alter the relat~~~nshqx
                        studied (I e.. DOD‘s workmg (apIta adjustment factor and contractor’s expected financmg I’OSTSI



                         Page 3                                      GAO/NSIABW33       Working Capital Financing Cwts
B224639




DOD'S  current policy. For contracts that had a total value of about $12
billion, the working capital profit factors would be underestimated by a
factor of 10 percent or more, whereas for contracts with a total value of
about $13 billion, the working capital profit factors would be overesti-
mated by a factor of 10 percent or more. These variations result because
DOD'S working capital profit factor does not adequately consider the
effects of the timing of contract cost expenditures and their relationship
to delivery payments.

DOD'S methodology and guidance recognize in a general way that deliv-
ery payments reduce working capital financing costs. It simplifies the
calculation of working capital costs by assuming that the average time
elapsed between incurring costs and receiving delivery payments is the
same for all contracts with delivery schedules of a similar length. The
projected cost expenditure data from our sample contracts, however,
show that the level of expenditures varies from month to month. Varia-
tions in the timing of these cost expenditures and delivery payments
affect financing costs in ways that are not accounted for by the DOD
working capital profit factor.

DOD's guidance instructs the contracting officer to make adjustments
under certain circumstances. For example, the guidance states that “the
contracting officer may adjust [contract costs] where the contractor has
a minimum cash investment.”

While the guidance provides the latitude to make these adjustments, the
policy does not provide specificity as to when and how to consider the
variations in the timing of cost expenditures and delivery payments. For
example, discussions with contracting officers and pricing analysts indi-
cated that DOD'S profit policy does not provide them with guidance that
would enable consistent adjustments to contract costs and contract
length. Therefore, the necessary adjustments to contract costs and con-
tract length may not always be made. These adjustments should be
made because they reduce the contractor’s financing requirements.

The following examples show how the timing of contractor cost expend-
itures and delivery payments on two contracts affect the amount of
financing costs even though contract costs and adjusted contract length
are similar. Additional details on these examples are contained in appen-
dix III. These examples highlight the methodology used in preparing this
report.




Page 4                            GAO/NSIAD-SO-33 Working Capital Financing Costs
              E-2246.39




              On one contract with a cost of $121 million, and an overall length of 55
              months, we calculated working capital financing costs of $2.8 million,
              whereas application of DOD'S profit policy showed that financing costs
              would be $2.4 million.

              During the first half of the 55-month contract, before any deliveries
              were made, the contractor incurred about 70 percent of the contract
              costs. During the final 26 months of the contract, the contractor
              incurred the remaining 30 percent of contract costs. In months 29 and
              30, the contractor received payments for deliveries made. These deliv-
              eries accounted for 50 percent of the value of the items to be delivered.
              Two other deliveries were made, one in month 39 and one at the end of
              the contract. Under this contract, the contractor would incur higher
              working capital costs during the first half of the contract and signifi-
              cantly lower costs thereafter.

              Unless adjustments are made to the working capital profit factor, appli-
              cation of DOD’S methodology would result in a lower profit objective
              because it does not recognize that the contractor’s investment was much
              higher during the first half of the contract than the second half.

              In contrast, on another contract with a cost of $118 million and an over-
              all length of 48 months, we calculated working capital financing costs of
              $1.2 million. DOD’s profit policy would have allowed an amount for
              working capital financing costs of $2.3 million. On this contract, only
              about 20 percent of total contract costs were incurred during the first
              half of the contract. Deliveries began at about this point and continued
              throughout the remainder of the contract.

              DOD’S  methodology, unless adjustments are made, would result in over-
              recognition for working capital financing costs on this contract because
              it does not recognize that the contractor’s investment was not very sig-
              nificant during the first half of the contract. Delivery payments later
              reduced the amount of the contractor’s investment.


                   awards contracts each year involving many millions of dollars in
Conclusions   DOD
              working capital profit. DOD's profit policy of generally recognizing work-
              ing capital appears to provide for profit objectives that approximate
              working capital financing costs on contracts in the aggregate. We found.
              though, that if DOD's methodology is applied without adjustments there
              can be significant variations on individual contracts. Current guidance
              provides general instructions on when and how such adjustments should


              Page 6                            GAO/NSIAD-9033   Working Capital Financing Costs
                  5224639




                  be made, and DOD acknowledges the importance of contracting officers
                  using their judgment to make adjustments.

                  When we initiated our review, the working capital profit policy had not
                  been in effect long enough for data on actual working capital cost to be
                  available. Our finding that the policy in the aggregate seems accurate
                  but can result in sizable variations on individual contracts, is based on
                  our analysis of projected contractor working capital needs. We believe it
                  will be important for DOD to monitor actual experience with the policy to
                  ensure that both the government and individual contractors are treated
                  equitably under the policy.


Agency Comments   draft of this report. Our draft report proposed that DOD revise its meth-
                  odology for determining the working capital profit factor.

                  DOD  stated that the working capital profit factor was intended to give
                  general recognition to some factors that affect contractors’ costs for
                  working capital under varying circumstances, not to calculate these
                  amounts precisely. We recognize that the working capital profit objec-
                  tive is only one part of the overall profit policy and further that overall
                  profit on negotiated contracts can represent only a portion of contract
                  price. The report has been revised to more clearly present this.

                  DOD  stated that the policy relies heavily on the contracting officer’s judg-
                  ment in adjusting the values of the various components that are used to
                  develop the factor. We agree that the contracting officers should use
                  their judgment in establishing the values of the various components that
                  are used to develop the factor.

                   Because of this and because of the limited actual experience with the
                   new policy at the time of our review, we are not making any recommen-
                   dations in this report. We believe, however, that DOD needs to monitor
                   the implementation of the policy over time to assure that it results in
                   equitable, consistent treatment of working capital financing costs.


                   We plan to distribute this report to interested parties and make copies
                   available to others upon request.




                   Page 6                            GAO/NSIAD96-33 Working Capital Financing Costs
B-224639




This report was prepared under the direction of M r. Paul F. Math, Direc-
tor, Research, Development, Acquisition and Procurement Issues, who
may be reached on ((202) 275-4587 if you or your staff have any ques-
tions Other major contributors to this report are listed in appendix V.

Sincerely yours,




Frank C. Conahan
Assistant Comptroller General




Page 7                            GAO/NSlAMO-33   Working Capital Financing Costs
                                          -

Contents


Letter                                                                                               1

Appendix I                                                                                          10
Defense Contractors’     Background                                                                 10
                         DOD’s Profit Policy Does Not Always Compensate                             13
Working Capital              Contractors Accurately for Working Capital
Financing Costs              Financing Costs
                         Adjustments to Contract Length and Estimated Costs                         I6
                             Materially Affect DOD’s Computation of Financing
                             costs

Appendix II                                                                                         18
Objectives, Scope, and
Methodology
                                          -
Appendix III                                                                                        21
Examples of Projected
Working Capital
Financing Costs
Estimated Using Data
Submitted by
Contractors
                                          -
Appendix IV                                                                                         25
Comments From DOD        GAocomments                                                                28


Appendix V                                                                                           29
Major Contributors to
This Report




                          Page 8                         GAO/NSlAB9@33   Working Capital Financing Costs
         Contents




Tables   Table I. 1: Summary of Fixed-Price Contracts W ith                           10
             Progress Payments
         Table 1.2: Summary of Comparison of Estimated Working                        14
             Capital Profit Factor and Predicted Financing Costs




          Abbreviations

          DFAIR     Defense Financial and Investment Review
          DOD       Department of Defense


           Page 9                         GAO/NSL4D9O-33   Working Capital Financing Costs
Appendix I

DefenseContractors’Working Capital
Financing costs

                                    DOD revised its profit policy in October 1986 to include for the first time,
Background                          a Drofit factor to recognize explicitly contractors’ costs of financing
                                    wbrking capital for w&k in process costs-material, labor, and
                                    overhead.

                                    DOD’S  profit policy is applied to contract actions where price is to be
                                    negotiated.’ The profit policy provides a range of profit factors applied
                                    by DOD contracting officials to several categories-contract    perform-
                                    ance, contract risk, and facilities capital employed-to arrive at a total
                                    profit objective used in negotiating contract profit. The working capital
                                    profit factor is part of the contract risk element.

                                    The working capital profit factor applies to fixed-price contracts for
                                    which progress payments are authorized. The profit policy provides an
                                    implicit working capital profit factor for contracts that do not receive
                                    progress payments.

                                    In fiscal years 1985-87, DOD’S data indicated that it negotiated 2,015
                                    fixed-price contracts for which progress payments were auth0rized.l
                                    Table I. 1 presents a breakdown of these data by years.

Table 1.1: Summary of Fixed-Price
Contracts With Progress Payments                                                                                   Authorized customary
                                                                                                                  progress payment rate
                                    Fiscal year                                 Number of contracta                             (percent)
                                    1985                                                             676                         90to80a
                                    1SA6
                                     __.                                                             662                                80
                                    1907                                                             677                                75
                                    Total                                                          2.015
                                    aProgress payment rate decreased from 90 to 80 percent on May 1 1965 The progress payment rate
                                    decreased from 60 to 75 percent on October 16, 1986.
                                    Source Data from DOD Form DD-350 (Indlwdual Contracting Actjon Report)

                                    Fixed-price contracts can be eligible for either customary progress pay-
                                    ment rates at the rates shown in table I. 1, or flexible progress payment
                                    rates, which are higher than the customary rate. Flexible progress pay-
                                    ments are designed to recognize that working capital financing costs



                                    ‘The profit policy applies to contract actions where price is to be negotiated and the contract action is
                                    valued at $500,000 or more. DOD issued the revised profit policy Initially on an interim basis, effec-
                                    tive October 1986. It was wued, with some changes, as a final rule, effective August 1987.

                                     ‘See note under source m table 1.1



                                     Page 10                                        GAO/NSIAD9033       Working     Capital Financing Costs
                          Appendix I
                          Defense Contractors’   Working   Capital
                          Financing Costs




                          may be higher than those costs anticipated by customary progress pay-
                          ment rates when considering the time difference between when contrac-
                          tors pay for costs incurred and when they are reimbursed for these
                          expenses. Contractors may then qualify for a flexible progress payment
                          rate that is higher than the customary rate. To determine the flexible
                          rate, DOD has developed a computer program that uses contractors’ pro-
                          jections of monthly incurred cost and delivery data over the contract
                          life. These data are audited by the Defense Contract Audit Agency.
                           According to DOD officials, the data necessary to establish flexible prog-
                           ress payment rates are generally submitted before the negotiation of
                           contract price.


Why a Working Capital     DOD’S  move to include an explicit working capital profit factor into the
                          profit policy stemmed from the Defense Financial and Investment
Profit Factor Is Needed   Review (DFAIR). DFAIR was a DOD study of the integrated effect of con-
                          tract pricing, financing, and profit, which was completed in June 1985.

                          Historically, the government has not recognized interest costs as an
                          allowable contract cost. Instead, the government has found it economical
                          to provide financing to contractors through progress payments, which
                          reduce the contractor’s need to borrow money. Also, the government
                          uses progress payments partly because it can borrow money at a lower
                          rate than the contractor. This presumably reduces overall contract
                          costs. Before the current profit policy was established, DOD compensated
                          contractors for the expense of financing working capital requirements
                          implicitly through the contract risk profit factor. Operating costs not
                          covered by either delivery or progress payments may have to be
                          financed by commercial borrowing.

                          DFAIR    concluded that    needed to explicitly link its contract financing
                                                       DOD
                          policies with its profit policy. DFAIR stated that the heightened aware-
                          ness of the time value of money and other cash management concerns
                          makes it imperative to develop an explicit link between contract financ-
                          ing and profit. The revised profit policy attempts to accomplish this
                          objective by providing a methodology that generally recognizes the
                          working capital costs that would not be financed through progress pay-
                          ments or delivery payments.


Working Capital Profit     DOD’S profit policy provides a methodology, similar to simple interest, to
Adjustment                 determine the working capital profit factor on an individual contract
                           basis. Basically, the methodology is as follows:


                           Page 11                                   GAO/NSIAB90-33   Working   Capital   Financing   Costs

                                                                      ,
                           Appendix I
                           Defense Contractors’   Working   Capital
                           Financing Costs




                           Portion financed         by contractor     x interest rate x contract           length
                           factor = working         capital profit    adjustment

                           The contractor’s share of financing is generally the portion not covered
                           by progress payments. The contract length factor represents the period
                           of time that the contractor has a working capital investment in the con-
                           tract. The contracting officer uses a table provided in the profit policy to
                           establish the contract length factor. Contract length is adjusted to
                           reflect the timing of deliveries and periods of inactivity. The working
                           capital profit factor is limited to a 4-percent ceiling of allowable contract
                           costs. The interest rate used is the rate promulgated by the Secretary of
                           the Treasury under Public Law 92-41. According to DOD, the interest
                           rate, length factor, and the 4-percent ceiling were set so as to result in a
                           conservative estimate of the working capital profit factor. Further,
                           according to DOD officials, contracting officers’ judgment, on such things
                           as periods of inactivity, represent an important part of the working cap-
                           ital profit factor.

                           DOD  developed this methodology primarily based on its DF.41R study. In
                           that study, DOD used 12 contracts to draw conclusions about contract
                           costs, delivery patterns, and contract lengths. In DFAIR, DOD used a model
                           based on unreimbursed monthly costs to establish its methodology for
                           calculating working capital financing costs. Our methodology was based
                           on DFAIR’S model of unreimbursed monthly costs. We evaluated the
                           model and found that it took into account the important factors that
                           affect working capital financing costs.


Cost Input and Contract    In determining the profit objective that will be allowed for contractors’
                           working capital costs, DOD’s profit policy states that certain adjustments
Length Adjustments Based   may be made for contract costs in which the contractor has a minimum
on Contract Profile        cash investment. For example, the policy states that contract length be
                           adjusted for the amount and timing of delivery payments that the gov-
                           ernment makes to contractors because these payments reduce their
                           working capital financing costs. In addition, total contract costs should
                           be adjusted when subcontracts are authorized for progress payments
                           because these arrangements reduce the prime contractor’s working capi-
                           tal investment.

                           Adjusted contract length is determined by eliminating periods of con-
                           tractor inactivity. For example, the time that the contractor begins
                           incurring significant amounts of costs may be several months after the
                           contract award date. Also. a contract may not be closed out for months


                            Page 12                                   GAO/NSL4D90-33   Working   Capital   Financing   Costs
                      Appendix I
                      Defense Contractors    Working   Capital
                      Fiiancing costs




                      after the last delivery is made and the last significant cost incurred.
                      These time periods, according to DOD,should not be included in contract
                      length. In addition, the contracting officer is required to adjust contract
                      length on contracts with multiple deliveries. M)D is not explicit about
                      how this adjustment should be made for all contracts. Our discussions
                      with contracting officers indicate that the necessary adjustments to con-
                      tract costs and contract length may not always be made because the
                      guidance lacks specificity.


                      Working capital financing costs on negotiated contracts amount to hun-
DOD’s Profit Policy   dreds of millions of dollars every year. If DOD’Smethodology for deter-
Does Not Always       mining contractors’ working capital requirements does not adequately
Compensate            recognize these costs, inequities in profit objectives either to contractors
                      or to the government may result on a contract-by-contract basis.
Contractors
Accurately for        Our analyses of the relationship between the working capital profit fac-
                      tor and contractors’ expected financing costs were based on 352” con-
Working Capital       tracts from a universe of 2,015 for which detailed data about the
Financing Costs       expected timing of contract expenditures were available. The 352 con-
                      tracts used in our sample had a projected value of approximately $3 1.6
                      billion, Our analysis, which was based on the contractors’ monthly
                      unreimbursed costs, showed that total working capital financing costs
                      for these contracts to be about 1.4 percent of the total contract costs.
                      Applying WD’S methodology for estimating the working capital adjust-
                      ment factor to the contract data we collected also indicated the financ-
                      ing cost to be about 1.4 percent. However, the impact on individual
                      contractors varied-DOD’s policy would result in overestimating the
                      working capital costs on many contracts while underestimating on many
                      others.

                       We compared the working capital profit factor and the estimated financ-
                       ing costs on a contract-by-contract basis. The results showed that for
                       approximately 87 percent of the 352 contracts, representing about 80
                       percent of the dollar value, or $25 billion, discrepancies between profit
                       negotiation objectives and financing costs of 10 percent or more could be
                       expected from working capital profit factors negotiated under DOD’Scur-
                       rent policy. For contracts valued at about $12 billion, our analysis

                       “Our analyses of whether the profit policy achieves DOD’s objective of prowding contractors wth
                       reimbursements that approximate contractors‘ financmg costs are based on data from 168 contracts
                       The 168 contractS could be protected to represent about 352 contracts with flexible progress pay-
                       ments. Flexible progress payment contracts include about 70 percent of the dollar value UPall 1.694
                       contracts recewlng pmgress payments.



                       Page 13                                       GAO/NSlAIMO-33      Working   Capital   Financing   Costs
                                          Appendix I
                                          Defense Contractors’   Working   Capital
                                          Financing Costs




                                          showed that the contract would be assigned a profit objective that was
                                          at least 10 percent under the predicted financing costs. For contracts
                                          with a total value of about $13 billion, the analysis showed that the con-
                                          tracts’ profit objective would be at least 10 percent over the predicted
                                          financing cost. These variations result from DOD’S working capital profit
                                          factor, which does not adequately consider such things as the effects of
                                          the timing of contract cost expenditures and their relationship to deliv-
                                          ery payments.


Estimated Working Capital Profit Factor   Dollars bn millions
and Predicted Financing Cost9                                                                                                        Average   over/
                                                                                         Projected                                            under
                                          Estimated financing      costs                number of         Total price of             compensation
                                            (percent)                                    contracts            contracts                   (percent)
                                          Close estlmatlon
                                          wthln + or -10                                          46               $6464                           -1
                                          Under estlmatlon
                                          -10 to -25                                              50                4,708                        -17
                                          more than -25                                          139                7,585                        -41
                                          Total                                                  189               12.293
                                          Over estlmatlon,
                                          +lO to +25                                              34                3,613       -~                +I8
                                          more than +25                                           82                9,270                         +79
                                          Total                                                  116               12,883
                                          Total                                                  352             $31,640
                                          Note Entries may not add due to roundmg
                                          aAll entries are subject to sampling error For example, the estimate from the first column that 07 per
                                          cent (all but 46 contracts) would not be closely compensated IS contained in a 95.percent confidence
                                          Interval

                                           DOD’S  implementing regulations on the current profit policy clearly state
                                           that the formula is not intended to be an exact calculation of a contrac-
                                           tor’s cost of working capital. The policy gives only general recognition to
                                           cost input and delivery schedules. The results of our analysis, which are
                                           summarized in table 1.2, suggests that the policy can result in significant
                                           differences among most contracts.

                                           DOD’S  methodology, in its general recognition of working capital financ-
                                           ing costs, assumes that the average time elapsed between incurring costs
                                           and receiving delivery payments is the same for all contracts with deliv-
                                           ery schedules of similar lengths. Projected cost expenditure data from
                                           contracts in our sample showed that the level of cost expenditures on
                                           individual contracts varies from month to month. Our estimates of


                                           Page 14                                        GAO/NSW9033          Working     Capital   Financing   Costs
Appendix I
Defense Contractmd   Working   Capital
Financing costs




imputed financing costs were based on projected net monthly
unreimbursed contract costs (total monthly costs, less progress pay-
ments and delivery payments).

The following examples show how the timing of contractor cost expend-
itures and delivery payments affect the amount of financing costs even
though contract costs and adjusted contract length are similar. A com-
parison of results using DOD’S profit policy with our calculations pro-
duced important differences in financing costs in each case. Additional
details on these examples are in appendix III.

On one contract with a cost of $121 million, and an overall length of 55
months, we calculated working capital financing costs of $2.8 million,
while application of DOD’S profit policy resulted in financing costs of
$2.4 million, baaed on an adjusted contract length of 37 months.

 During the first half of the 55-month contract, before any deliveries
 were made, the contractor incurred about 70 percent of the contract
 costs. During the final 26 months of the contract, the contractor
 incurred the remaining 30 percent of contract costs. In months 29 and
 30, the contractor received payments for deliveries made. These deliv-
 eries accounted for 50 percent of the value of the items to be delivered.
 Two other deliveries were made, one in month 39 and one at the end of
 the contract. The cost and delivery data on this contract indicate that
 the contractor would incur higher financing costs during the first half of
 the contract and significantly lower costs thereafter. This pattern
 caused our estimate of financing costs being higher than DOD’s working
 capital profit factor would provide.

 DOD’s methodology would result in a lower negotiated profit objective on
 this contract because it does not recognize that the contractor’s invest-
 ment was much higher during the first half of the contract.

 In contrast, on another contract with a cost of about $118 million and an
 overall length of 48 months, based on the monthly cost input and deliv-
 ery profile of the contract, we calculated working capital financing costs
 of $1.2 million, DOD’S profit policy would have provided for a profit
 objective of $2.3 million baaed on an adjusted contract length of 37
 months. On this contract, only about 20 percent of total contract costs
 were incurred during the first half of the contract. Deliveries began at
 about this point and continued throughout the remainder of the con-
 tract, thereby reducing working capital requirements.



  Page 18                                GAO/NSL4D9O.33   Working   Capital   Financing   Costs
                           Appendix 1
                           Defense Contractors’   Working   Capital
                           Financing Costs




                           DOD’S  methodology could result in higher negotiated profit objectives on
                           this contract because its methodology for calculating working capital
                           does not take into account that the contractor’s investment was not very
                           significant during the first half of the contract. It also does not take into
                           account that delivery payments occurring during the period of heaviest
                           incurred cost reduced the amount of the contractor’s investment.


Adjustments to             need to be made for periods of inactivity, and subcontractor progress
Contract Length and        payments that are liquidated late in the period of prime contract per-
Estimated Costs            formance. The cash flow model adjusts for these things and does not
                           rely on the contracting officer’s judgment.
Materially Affect
DOD’s   h’nputation   of   When a subcontractor is authorized progress payments, the prime con-
                           tractor receives 100 percent of the progress payments paid to the sub-
Financing Costs            contractor. Theoretically, this contract relationship will reduce the
                           prime contractor’s investment. WD’s profit policy states that contract
                           costs may have to be reduced by those amounts. Therefore, when the
                           prime contractor has many subcontractors that receive progress pay-
                           ments, this may reduce the prime contractor’s financing requirements.
                           DOD officials explained that even when the prime contractor has many
                           subcontractors that receive progress payments, this does not necessarily
                           mean that the prime contractor’s financing requirements are reduced. A
                           critical factor is when the subcontractor delivers versus when the prime
                           contractor delivers, For example, when computing the working capital
                           adjustment factor. an adjustment to contract costs may be required
                           when the subcontractor delivers to the prime contractor and the prime
                            contractor immediately delivers to DOD. This situation may enable the
                            prime contractor to recover all unreimbursed costs paid to the subcon-
                            tractor. In this circumstance, excluding some portion of the costs paid to
                            subcontractors seem likely to produce more accurate results overall.

                            DOD’S policy does not specify any dollar value criteria to indicate when
                            such an adjustment should be made. For the contracts in our sample,
                            which had progress payments to subcontractors, these progress pay-
                            ments represented about 20 percent of the total contract costs. We
                            believe that some of the subcontract costs should be considered for
                            exclusion from the negotiated profit base. The following example dem-
                            onstrates the importance of this adjustment.

                            A 1985 Army contract for $181 million for helicopters and support
                            equipment had $41 million of subcontract progress payments. Using


                            Page 16                                   GAO/NSIABSOd3   Working   Capital   Financing   Costs
                            -
Appendix I
Defense Contractons    working   Cspltd
Financing costs




DOD’S formula, and without adjusting contract costs for these subcon-
tract costs, the prime contractor’s cost to finance this contract would be
$2 million. If contract costs were reduced by the amount of the subcon-
tract progress payments, DOD’S formula would result in financing cost of
$1.54 million, or $460 thousand (23 percent) less than if contract costs
were not adjusted.

We believe that DOD’S profit policy does not provide detailed guidance
that would enable its contracting officers to make adjustments consist-
ently to contract costs and contract length. Our calculations considered
many of the adjustments. Our discussions with contracting officers indi-
cate that the necessary adjustments to contract costs and contract
length may not always be made. This may be because the guidance lacks
specificity (i.e., defining periods of inactivity and adjusting for subcon-
tractor costs). Methodology based on net monthly unreimbursed con-
tract costs should consider such things as periods of inactivity.

DOD’S policy states that contract length should be adjusted for deliveries.
To show the importance of making this adjustment, we examined a sam-
ple that was projected to represent approximately 1,700 contracts.* We
estimated that if these adjustments for delivery payments were not
made, the contract length factor would be 38 months. When we adjusted
contract length for deliveries in accordance with DOD’S methodology, we
calculated an adjusted contract length of 24 months, suggesting the need
for lower requirements for working capital. The working capital profit
factor based on 38 months would be approximately 2 percent of con-
tract costs compared with 1.2 percent when length is adjusted.




 ‘As explained   earlier, according to DOD’s data, 2,015 negotiated fixed-price contracts were awarded
 in fiscal years 1986.87. which would most likely be subject to the working capital adjustment factor
 in DOD’s profit policy. We studied a sample of contracts that were projected to represent approxi-
 mately 1,700 contracts valued at $46 billion. See appendix 11for additional details on our sampling
 methodology



 Page 17                                        GAO/NSIAD90-33      Working   Capital Financing   Costs
Appendix II

Objectives,Scope,and Methodology


              The Senate Appropriations Committee, Subcommittee on Defense,
              requested that we review DOD’S profit policy to determine whether it
              appropriately considers a contractor’s working capital costs by taking
              into account the important factors that affect working capital.

              When we initiated our review, the working capital profit policy had not
              been in effect long enough for data on working capital costs to be availa-
              ble. Therefore, we collected data that would provide estimates of con-
              tract working capital costs for contracts awarded in previous years. We
              used the data from these contracts to compare the profit objectives that
              would be developed for working capital under the current profit policy
              with the working capital financing costs that contractors could be pre-
              dicted to incur.

              In fiscal years 1985-87, DOD data’ indicated that it definitized 2,015
              fixed-price negotiated contracts for which progress payments were
              authorized. We drew a probability sample of 425 contracts to represent
              all negotiated, fixed-price contracts that met the following conditions:
              contract obligation of at least $500,000, definitized in fiscal years 1985,
              1986, or 1987, authorized for progress payments, performed by a busi-
              ness enterprise in the United States, and obtained a certificate of current
              cost or pricing data. If these conditions were met, then the contracts
              would be eligible for application of the working capital profit policy.

              Our sample of 425 contracts included all of the 225 contracting actions
              that DOD reported as exceeding $30 million. We used probability sam-
              pling techniques to draw an additional 200 contracts to represent the
              remaining smaller contracting actions. These contracts were selected
              with probabilities of selection proportionate to the amount of funds obli-
              gated for the remaining contracts in the universe. Our review was lim-
              ited to contracts awarded to large businesses. Small business contracts
              were excluded because they represented only 10 percent of the total
              negotiated fixed-price contracts.

              We issued 425 questionnaires to defense contractors and requested
              information about the contract price and the timing of deliveries and
              other significant contract actions such as net monthly unreimbursed
              contract costs. (See app. III for additional details on the type of informa-
              tion that we received.) Of the 425 originally identified contracts, the
              returned questionnaires indicated that 367 of the contracts were those
              that would be eligible for application of the DOD working capital profit

              ‘Data obtamed from DOD’s Form 350 (Indiwdual Contractmg Actlon Report) data base



              Page 18                                   GAO/NSIAB9033     Working Capital Financing Costs
Appendix II
Objectives, Scope, and Methodology




policy. (The ineligible contracts consisted of 2 that were never executed
and 54 that were not negotiated contracts. No information was received
for two contracts.) Three additional contracts were excluded from the
analysis due to inadequate information about the dates of contract
actions.

Of the 364 contracts, 176 were contracts with customary progress pay-
ments, and 188 were contracts with flexible progress payments. When a
contract is authorized for flexible progress payments, more detailed
information is provided to the government concerning the amount, tim-
ing, and types of contract costs. Detailed cost data of the type furnished
for flexible progress payments is not required by the government for
contracts that use customary progress payments. We requested the
information for the flexible contracts in our sample because this infor-
mation is generally readily available for these contracts, whereas for the
contracts authorized customary progress payments, these data are not
required and would have required the contractor to provide these costs.
We did use the type of information that is available at the time of con-
tract negotiation and audited by the Defense Contract Audit Agency.
The purpose of our review was to evaluate the relationships between
DOD’S current policy on working capital and predicted working capital
financing costs for a probability sample of DOD contracts where data are
readily available.

We computed detailed analyses of differences between profits that could
have been negotiated for working capital under DOD’s current policy and
projected financing costs based on 168 (of the 188 contracts) with flexi-
ble progress payments for which contractors provided the planned cost
data. Twenty contracts were excluded from the analysis due to inade-
quate information on planned cost data. Our analyses of whether the
profit policy achieves DOD’S objective of providing contractors with
reimbursements that approximate contractors’ financing costs are baaed
on data from 168 contracts. The 168 contracts could be projected to rep-
resent about 352 contracts with flexible progress payments. Flexible
progress payment contracts include about 70 percent of the dollar value
of all 1,694 contracts receiving progress payments.

Unless otherwise indicated, the findings in this report are projections to
the universe of contracts with flexible progress payments from which
the sample was drawn. Thus, estimates of percentages and rates are
approximations of the universe baaed on the studied contracts. Esti-
mates of the total value of negotiated contracts we looked at may be
underestimates of totals because some of the contracts were not used for


 Page 19                             GAO/NSIAD90-33   Working   Capital   Financing   Costs
Appendix II
Objectives, Scope, and Methodology




two reasons: (1) three contracts with incomplete dates and the two con-
tracts for which no information was received are excluded from the pro-
jections and (2) there are probably some contracts that are eligible for
the profit policy but were excluded from our study because they were
incorrectly coded on the DOD Individual Contracting Action Reports.

We estimated the amount of working capital profit for each contract as
prescribed by the new policy. This profit objective is determined on an
individual contract basis by DOD's prescribed formula that considers
some of the factors that determine contractors’ working capital financ-
ing costs. In applying DOD's formula, we adjusted contract length in
accordance with DOD'S profit policy. We also eliminated periods of con-
tractor inactivity based on information provided by the contractors. We
used the date of submittal of the first progress payment request or date
when 2 percent of costs were incurred, whichever was earliest, as the
contract start date (rather than the date of contract award). We based
the contract completion date on the expected date of contract comple-
tion as indicated by the questionnaire results or date of last delivery.

We also estimated the working capital financing cost for each contract
for which cost and delivery data were provided. Our calculations are
based on projected monthly spending and delivery patterns and
unreimbursed costs that were initially expected for the contract as
determined by DOD's flexible progress payment computer model. The
data used for the model represents projections of contract costs expendi-
tures, not actual costs incurred.

During the review, we held discussions with DOD officials responsible for
developing the profit policy. We obtained information on how the work-
ing capital profit policy was derived and also on DOD'S computerized pro-
gram for determining flexible progress payments. We talked with DOD
contracting officers and pricing analysts to determine how the working
capital profit policy was being implemented. We discussed the results of
our review with responsible DOD officials.

Our review was performed from March 1988 through December 1989 in
accordance with generally accepted government auditing standards.




Page 20                              GAO/NSlAD90-33   Working   Capital   Financing   Costs
Appendix III

Examples of ProjectedWorking Capital
FinancingCosts Estimated Using Data
Submitted by Contractors
Example     I:
                                                                                 Cum
                                                                  Cum       delivery         Contractor
                       Monthly                               progress     payments       unreimbursed              Time          Financing
Month                    costs        Cum costs             payments          (0009)               costs         (days)               costs
1                       $2.760            $2,760                $2208              $0                $552             30                  $4
2                         2,760            5,520                  4416               0              1 104             31                    a
3                         3,396            8,916                  7.133              0              1,783             31                   13
4                         3,396           12,312                  9850               0              2,462             30                   17
5                         3,611               15,923            12.738               0               3,185            31                   23
                                -
6                         3,613               19,536            15,629               0               3,907            30                   27
7                         3,613               23,149    -       18.519               0               4,630            31                   ii
8                         3,572               26,721            21377                0               5,344            31                   39
9                         2.835               29,556            23,645               0               5,911     ~      28~~~       -~~      39
10                        2-                  32,391            25,913               0               6,478            31                   47
11                         2,876              35,267            28,214               0               7,053~~__        30-~.                49
                                                                                                                                   -~~
12                         2,876              38,143            30 514               0               7,629            31                    55
                                                                              ~~. .~         __-.
13                         2,876              41.019            32.815               0               8,204            30                   57
14                         2,876              43,895            35116                0                8,779            31                   63
15                         2,873              46,768            37414                0                9.354            31                   68
                      -~____~~                                  ~~ ..._~
16                         2,862              49,630            39704                0                9,926            30                   66
17                         2,862              52,492            41994 -~             0 --           10,498             31                   76
la                         2,862              55,354         ~- 44283                0              11 071             30                   77
19                         2,862              58.216            46,573               0              11,643             31                   a4
20        ____-            2.806               61,022           48.818               0              12,204             31                   aa
21                         2,829               63,851           51,081                              12,770             28                   a3
22                         2,829               66,680           53,344                              13.336             32                   99
23                         3,039               69,719           55,775                               13,944            30                   97
24                         3,039               72,758           58.206                               14,552            31                 ~105
25                         3039                75.797           60.637                               15,160            30                  106
26                         3,053               78,850           63,080 -----o--                      15,770            31                  114
                        _._____~                               ~~~--~
27                         3,054               81,904           65,523               0               16 381            31                  118
                                                                                                    ~~__~~                        ~-      ~.~~
28                         3.054               84,958           67,966               0               16,992             15                  59
29                              0              84,958           67,966           2,241               14,751            15                   52
29                         3,204               88,162            70,529          2,241               15,392             15                  54
30                              0              88,162            70,529         12,250                5,383            16                   20
30                          3.054              91.216            72.973         12.250                5,993            30                   42
                  __.
31                          3,054              94,270            75,416         12,250                6,604            31                   48
32                          2,993              97,263            77,810         12.250                 7.203           31                   52
33                          1,392              98,655            78924          12,250                 7,481            28                  49
34                          1,392             100,047            80.037         12,250                 7 760            31                  56
35                          1390              101437             al 149-.2250-~~~-                     8.038            30                  56




                                    Page 21                                       GAO/NSIAD-SC-33      Working   Capital     Financing   Costs
                                                Appendix III
                                                Examples of Projected Working Capital
                                                Financing Costa Estimated Using Data
                                                Submitted by Contractors




                                                                                               Cum
                                                                             Cum          delivery          Contractor
                                    Monthly                             progress        payments        unreimbursed             Time     Financing
Month                                 costs         Cum costs         payments              (000s)                costs        (days)          costs
36                                     1.390           102.827             82.261           12.250                 8316             31             60
37                                     1,381           104,208        -    83,366        - 12,250                  8.592            30             60
38                                     1.381           105,589             84,471           12,250                 8,868            15 ~-          31
39                                          0          105,589             84,471           18,803                 2,315            16               9
39                                     1,382           106,971             85,576           18,803                 2,592            31              19
40                                     1,382           108,353             86,682           18,803                 2,868            30             20
41                                     1,534           109,887             87,909            18,803                3,175            31             23
42                                     1,382           111,269             89,015            18,803                3,451            30             24
43                                       907           112,176             89.740            18,803                3,633            31             26
44                                       868           113,044             90,435            18,803                3,806            31             27
45 -                                     849           113,893             91,114            18.803                3.976            28             26
46                                       849           114,742             91,793            18,803                4,146            31             30
47                                       838           115.580             92463             18.803                4314             30             30
48                                       838           116,418             93,134            18,803                4,481            31                  32
49                                       829           117,247             93,797            18,803                4,647            30                  32
50                                       829              118,076          94,460            18,803                4,813            31                  35
51                                       798              118,874          95.098            18.803                4.973            31                  36
52                                       798              119,672          95,737            18,803                5,132            30                  36
53                                       797              120,469          96,374            18.803                5.292            31                  38
54                                       926            121,395            97,112            18,803                5.480            15                   19
55                                         0            121,395            97,112            24,283                     0            0                    0
Total                                                 9121.395                                                                                       2.761
Estimate of working capital ftnancmg costs had DOD methodology        bee” used on contract I” our sample (See note 1 )                              2,373
Our projected fmancmq costs I” excess of DOD’s methodoloav                                                                                            $388
                                                NOTE 1’
                                                DOD methodology for computing flnanclng costs
                                                 Portlo” of contract costs financed by contracto?                                             $24,279
                                                 X Contract length factor”                                                                      1 150
                                                 x Interest rate                                                                              0
                                                 DOD flnanclng costs                                                                          -
                                                aThe contractors share of flnanclng IS generally the portlon not covered by progress payments
                                                bThls factor represents the period of hme that the contractor has a workmg capital Investment I” the
                                                contract DOD‘s proflt policy prowdes a table to establish the contract length factor The contract I” the
                                                example has an adlusted length of 37 months-the table I” the DOD policy !ndlcates that when the
                                                adjusted contract length is 37 months, the contract length factor should be 1 15




                                                Page 22                                        GAO/NSL4DSO33        Workhg    Capital    Financing   Costs
                                          Appendix ITI
                                          Examples of Projected Working Capital
                                          Fllcing   Costs Estimated Using Data
                                          Submitted by Contractors




Example   II:
                                                                                        Cum
                                                                        Cum        delivery         Contractor
                                Monthly                            progress      payments       unreimbursed             Time         Financing
Month                               costs       Cum costs         payments           (0009)               costs        (days)              costs
1                                        $4             $4 -~      .~.~~ $3                $0                 $1            31                 $0
2                                        14             18                 14               0                   4           31                   0
                                                                                                                                     ~~
3                                        17             35                 28               0                   7           28                   0
                                    --_
4                                        40             75                 60               0                  15           31                   0
5                                       336            411                329               0                  82           30                   1
6                                        23            434                347               0                  07           31                   1
7                                        52            486                389               0                  97           30                   1
8                                       246            732                586               0                146            31                   1
                         ..-.   -.-                                               ___~
9                                       660          1,392              1,114               0                278            31                   2
10                                  1,977               3,369 ~     ~. ~~2,695             0                 674            30                   5
II                                    531               3,900            3,120             0                 780            31                   6
12                                    810               4,710            3,768             0                 942            30                   7
                .____           -
13                                  1035                 5,745          4,596              0               1,149             31                  8
14                                  1,750                7.495      -‘-5   996             0               1,499             31                 11
15                                    646                8,141     - 6,513                 0               1,628             28                 11
16                                    872                9,013      -~ 7,210               0               1,803             31                 13
17                                  2.496               11,509         --9,207             0               2,302             30                 16
18                                  1240                12,749         10,199              0               2,550             31                 18
19                                  1.025               13,774     - 11 019                0               2,755             30                 19
                        ~-_
20                                  1,602               15,376         12,301              0               3,075             31                 22
21                                  1.136               16,512         13,210              0               3,302             31                 24
22                                  2,359               18,871     - 15,097               19               3,755             30                 26
23                                  3,030               21,901         17,521             19               4,361             31                 31
24                                  2,354               24,255         19,404            233               4,618             30                 32
25                                  3.188               27,443         21,954            662               4,827             31                 35
26                                  4299                31,742         25,394          1,091               5,257             31                 38
27                                  4,469               36,211        28,969           1,822               5,420             28                 35
28                                  4,244               40,455         32,364          2.411               5,680             31                 41
29                                  4.644               45,099         36,079          2,874               6,146             30                 43
30                                  4,987               50,086         40,069          3,496               6,521             31                 47
31                                   5,442              55,528         44,422          4,174               6,932             30                48
32                                   5,108              60,636         48,509          4,977               7,150             31                 52
33                                   5.579              66,215         52,972          5,593               7,650             31                55
34                                   5,960              72,175         57,740          6.182               8,253             30                 58
                        ~-
35                                   6,322              78,497         62,798          6,982               8,717             31                 63
36                                   6,336              84,833         67,866          8,996               7.971             30                 56
                                                                                                                                      (continued)




                                              Page 23                                    GAO/NSiAD-90-33     Working   Capital    Financing   Costs
                                             Appendix III
                                             Example3 of Projected working Capital
                                             Financing Costs Edmated    Using Data
                                             Submitted by Contractors




                                                                                              Cum
                                                                            Cum           delivery          Contractor
                                     Monthly                           progress         payment5        unreimbursed             Time             Financing
Month                                  costs       Cum costs          payment5              (0005)                costs         Ways)                  costs
37                                      5,450          90,291             72,233              0,368                7,690            31                     56
~--~--
38                                      5,531          95,822             76,658              2.146                7,018            31                     51
59                                      4.770         100,600             80,480              2,985                7,135            29                        48
40                                      3,012         103,612             82.890              4,236                6,486            31                        47
41                                      3,311         106,923             85,538              4,791                6,594            30                        46
42                                      3,094         110,017             88,014              5,903                6,100            31                        44
43                                      2,196           112,213            89770             17,075                5,368             30                       38
44                                      2,946           115,159            92,127            18.803                4,229             31                       31
45                                        870           116,029            92,823            19,975                3,231             31                       23
46                                        911           116,940            93.552            21,703                1,685             30                       12
47                                        865           117,805            94,244            23,000                  561             31                        4
48                                        284           118,089            94,244            23,845                     0                 0                    0
Total                                                 $118,099                                                                                             1,224
 Estimate of working capital financmg costs had DOD methodology       been used on contract In our sample (See note2)                                      2,309
 Our projected flnanclng costs in excess of DOD's methodology                                                                                             $1085
                                                NOTE 2
                                                DOD methodology for computing fmancmg costs
                                                 Portton of contract costs financed by contractora                                                        $23.618
                                                 X Contract length facto+                                                                                   1 150
                                                 X Interest rate                                                                                          0085
                                                 DOD flnancmg costs                                                                                       $2.309
                                                aThe contractor’s share of flnanclng IS generally the portlon not covered by progress payments

                                                DThls factor represents the penod of tune that the contractor has a working capital w?stment I” the
                                                contract DOD‘s proflt policy provides a table to establish the contract length factor The contract I” the
                                                example has an adjusted length of 37 months-the      table in the DOD poky lndlcates that when the
                                                adjusted contract length IS 37 months the contract length factor should be 1 15




                                                Page 24                                         GAO/NSIAD-90.32       Worldng   Capital       Financing     Costs
I2ppendix I\

CommentsFrom DOD


Note GAO comments
supplementing those !n the
report text appear at the
end of this appendix                                                       ASSISTANT    SECRETARY   OF DEFENSE
                                                                                  WASHINGTON. 0 c 203Ob8000




                                 PROD”CTlON         AND                                                       May 31,      1989
                                     LOCISTIC5
                                      (P)CPF



                                          Mr.       FrankC. Conahan
                                          Assistant       Comptroller             General
                                          National      Security         and      International
                                             Affairs      Division
                                          United     States      General          Accounting         Office
                                          Washington,        DC 20548

                                          Dear       Mr.     Conahan:
                                                 This     is the Department          of Defense     (DOD)     response    to the
                                          General       Accounting     Office    (GAO) draft       report,      "GOVERNMENT
                                          CONTRACTING:           Compensation       of Defense     Contractors'        Working   Capital
                                          Financing        Costs,"   dated    April      13, 1989 (GAO Code 396117),           Case
                                          7679-A.        The DOD disagrees          with    the basic     premise    on which    the GAO
                                          report      is based.

                                                  The GAO draft          report       reflects       a basic       misunderstanding            of the
                                          intent      of the Department              in including          the working        capital        adjust-
                                          ment factor         as one part          of the weighted            guidelines       profit        policy.
                                          It is not the objective                  of the profit           policy      to attempt        to recog-
                                          nize     contractors'         cost     of financing          working       capital     at a rate           that
                                          approximates          their     costs,       as the GAO report             states.       The working
                                          capital       adjustment        factor       is intended         to give general            recognition
                                          to a contractor's             cost     of working         capital       under varying          circum-
                                          stances,       not    to calculate           these     amounts      precisely.         The policy
                                          itself      clearly      states      this      intention.

                                                   One of the DOD objectives                    in including           the working        capital
                                           adjustment        factor      as part        of the profit           policy      was to provide           a
                                           simple      but explicit          link     between        contract       financing        and profit
                                           policies.         Thus,     the working           capital       adjustment         factor     specifi-
                                           cally     recognizes        that      working       capital       requirements          vary with        (1)
                                           the contract          circumstances,             (2) the level           of progress         payments,
                                           and (3) the prevailing                  interest        rates.       As these        factors      vary,      the
                                           working      capital       adjustment          amount automatically                changes,       as does
                                           the total       profit      objective.            For example,           the factor        provides
                                           additional        working       capital        amounts       if the progress            payment      rate      is
                                           reduced      or if interest            rates      increase;         conversely,         and it provides
                                           reduced      working       capital        amounts       if the progress            payment      rate    is
                                           increased       or if interest             rates      fall.

                                                     Another      of     the    DOD   objectives        in establishing          the current
                                           profit       policy         was to    reduce        the   emphasis   placed        on estimated           cost

                             L

                                                    page25                                            GAO/NSIAD%l33WorkingCapitalFinancingCosts
                          AppendixIV
                          CommentsFrom         WD




                in the development               of a profit         objective      and to increase           the
                emphasis      placed        on contractor          investment.         This    objective        was
                accomplished,           in part,        through      the establishment           of a separate
                factor     within      the weighted           guidelines       policy     for recognizing
                working     capital         requirements          on the contract.            Prior    to the
                implementation            of the current           policy,     working      capital      had been
                implicitly        considered          in the development            of profit       objectives;
                now, working          capital       is given       explicit     consideration          in the
                development         of profit         objectives.

                        The GAO states            that,        based on its            simulation         of the policy
                and its      projections           of working            capital        costs      expected        to be
                incurred       on a number           of contracts!               the policy         would     not compensate
                contractors         at a rate          that      approximates             their     financing         costs.
                The DOD does not agree                   with       the GAO on the degree                  of precision
                required.         A much more complicated                        calculation           would     clearly       have
                to be developed            in order           to estimate            more closely          projected
                financing       costs.         Contracting              officers        would,       in most instances,
                need to obtain            additional            detailed         information           on projected           cost
                incurrence        patterns         in order           to perform          a more precise             calcula-
                tion.       The current          policy         was deliberately                designed       to provide          a
                relatively        simple       process          for developing              the working          capital
                adjustment        factor.          The policy            heavily        relies      upon the contracting
                officer      to use judgment                in establishing               the values         of the various
                components        that     are used to develop                     the factor.            The policy
                includes       guidance        on the types               of issues         that     should      be considered
                by the contracting               officer          in developing             the values         of these
                components.

                        Further,        the Department             does not agree with                the methodology
                used by the GAO to simulate                      the application              of the working              capital
                adjustment         factor.         Therefore,           the    DOD does not agree               with      the GAO
                finding       that     contractors          may be U1overcompeneatedU~                   in many cases.
                In performing            its    simulation,           the GAO did not have access                       to the
                same    types      of information             that      are available           to a contracting
                officer       during       the contract          negotiation            process      and, thus,           the GAO
                could     not make the same types                     of adjustments            that    a contracting
                officer       would      make.        For example,           based on discussions                 with      the
                GAO auditors,            it is clear          that      no adjustments            were made for the
                amount      of subcontractor              progress          payments,        even though          the policy
                clearly       states       that     the contracting             officer       should       make an adjust-
                ment when the contractor                    has a minimum            cash investment,               such as
                when subcontractor                progress       payments         are liquidated             late     in the
                period      of contract           performance.              The contracting            officer       would
See comment 1   have access          to the types           of information              that    would      enable       such an
                adjustment:          the GAO did not have access                        to the same information                   to
                enable      it to adjust            for   this      factor.

                        Additionally,          the GAO fails         to acknowledge          that    the working
See comment 2   capital       adjustment        factor     was established           in a very      conservative
                manner.        For example,          the individual         contract      length      factors    have
                been reduced          by a factor        of .35,      which    automatically          results    in
                lower     working      capital       amounts.       The Treasury        rate      is used in the




                            Page26                                              GAO/NSIAD90-33WorkingCapitalFinancingCosts
               Appendix IV
               Comments From DOD




                                              -
-


    calculation         of the working              capital      amount,    not the contractor's
    actual      borrowing         rate     or commercial          borrowing      rates,      which   also
    results       in lower        working       capital       amounts.      Finally,       the working
    capital      amount       is capped         so that       it cannot     exceed      4 percent      of the
    total     cost     objective.            Thus,      on an individual         contract,       the DOD
    would     expect      that      the working          capital     adjustment       factor     would
    usually      result       in %ndercompensationOq                 of amounts       for working
    capital,        and would         rarely      result      in any "overcompensation."

             The weighted           guidelines          profit       policy      is used to develop            a
    Q&.&       profit       objective         for    non-competitive              contracts.       There      is   no
    separate          negotiation        of amounts            for contractor           working    capital.
    To characterize               a variation          in one factor            used to establish           a
    profit       objective         as potentially              resulting        in "excessive       profits"
    is very       misleading,           particularly             for    individuals         who are not
    familiar         with     the entire          process        of developing          cost    and profit
    objectives           and negotiating             contract         price.

            For these     reasons,      the Department    does not agree                          that    it is
    necessary      to revise       the methodology     used to calculate                           the   working
    capital     adjustment      factor.

         Thank you           for providing           the     DOD with       the     opportunity          to
    comment on the            draft  report.

                                                           p;ifice=eW,




                                                     (Production          and     Logistics)




                                                                                                                        J




                Page 27                                            GAO/NSIAB90-33         Working Capital Financing Costs
-
    Appendix IV
    Comments From DOD




    DOD’S methodology for computing working capital costs would not ade-
    quately recognize a contractor’s working capital costs-would not
    change whether or not we adjusted for payments to subcontractors.
    Over 65 percent of the contracts in our sample do not provide for prog-
    ress payments to subcontractors. Many of these contracts continue to
    show that applying WD’S current profit policy would result in overesti-
    mates or underestimates of working capital financing costs. Further, the
    percentage of contracts with no payments to subcontractors that are
    over or under compensated are within 3 percent of those in table 1.2. If
    we adjusted prime contracts with progress payments to subcontractors
    when applying DOD’S methodology, it could result in an overall lower net
    compensation of working capital amounts. However, we were not able to
    make adjustments to prime contracts with progress payments to subcon-
    tractors because the DOD policy is not clear enough to make these adjust-
    ments consistently.

    2. DOD stated that we failed to acknowledge that the working capital
    adjustment factor was established in a very conservative manner. For
    example, DOD stated that the (1) individual contract length factors have
    been reduced by 0.35 percent which automatically results in lower
    working capital amounts, (2) Treasury rate is used in calculating the
    working capital amount, not the contractor’s actual borrowing rate or
    commercial borrowing rates, which results in lower working capital
    amounts, and (3) the working capital amount is capped so that it cannot
    exceed 4 percent of the total cost objective. We agree that these factors
    may tend to result in a conservative estimate of overall working capital
    financing costs, and we found that DOD’S method for calculating working
    capital costs overall would probably not result in overcompensation.
    The main point of this report is that despite this conservative approach,
    DOD’S methodology results in overestimates or underestimates of work-
    ing capital cost in numerous instances.




     Page 28                          GAO/NSL4DSO-33   Working   Capital   Financing   Costs
Appendix V

Major Contributors to This Report


                        Clark G. Adams, Assistant Director
National Security and   Ralph C. Dawn, Assignment Manager
International Affairs   James M. Fields, Social Science Analyst
                        Alfred Lilliendahl, Operations Research Analyst
Division, Washington,
D.C.

                        Joseph F. Daly, Assistant Regional Manager
Philadelphia Regional   James A. Przedzial, Evaluator-in-Charge
Office                  D. Richard Stengel. Evaluator




(396117)                Page 29                          GAO/NSL4D99-33   Working   Capital   Financing   Costs
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