Defense Industry Restructuring: Clarification of Cost and Savings Issues

Published by the Government Accountability Office on 1997-06-17.

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

      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      National Security and
      International AfTairs Division


      June 17, 1997

      The Honorable Tom Harkin
      United States Senate

      The Honorable Peter A. DeFazio
      The Honorable Christopher H. Smith
      House of Representatives

      Subject: Defense Industrv Restructuring: Clarification of Cost and Savings Issues

      Over the past 3 years, we have issued a series of reports on reimbursements to
      defense contractors for restructuring subsequent to their business combinations.
      On June 10, 1997, you asked our office to address several questions related to
      those reports. This letter responds to your request, and a list of our reports on
      restructuring appears .at the end of this letter.


      (1)    Can DOD’s claim that savings are resulting from its policy of
             reimbursing   contractors for merger-related   restructuring costs be
             verified by reviewing the accounting records of the merging
             companies?    What is the difference   between a cost avoidance and

      The -“savings”from restructuring activities are generally in the form of future
      cost avoidances, which are not recorded in a contractor’s accounting records.
      Defense contractors are required to maintain accounting records showing the
      actual amount and nature of costs charged to government contracts, but these
      records do not reflect costs that would have been incurred had an action-such
      as restructuring-not occurred. Consequently, restructuring “savings” have to
      be estimated using assumptions about what costs would have been had a
      merger or an acquisition not occurred.

      The Department of Defense (DOD) has defined cost avoidances, in discussing
      the impact of acquisition reform efforts, as “cost reductions resulting in

                                                   GAO/NSIAJ%97-186R Restructuring   Savings

avoidance of costs that were not budgeted,” and it has defined savings as “cost
reductions from an approved budget baseline that result in program funds being
recouped or used elsewhere in the program.” Prom a budgetary perspective,
DOD’s definitions would imply that cost avoidances do not affect budgetary
requirements, while savings may, depending on whether they were simply
applied elsewhere within a program.

(2)      How much has DOD spent on taxpayer funded restructuring       and
         has DOD cited any specific cases where this restructuring  has
         directly caused an actual reduction in contract or product prices?

The Defense Contract Audit Agency (DCAA) estimated that as of September 30,
1996, DOD had reimbursed 4 business combinations about $179 million toward
its share of the costs the combinations had incurred for restructuring activities.
Of this amount, about $18 million was the additional cost resulting from DOD’s
decision in July 1993 to allow restructuring costs to be charged to flexibly
priced contracts transferred from one company to another, provided that the
savings from restructuring exceeded those costs or the merger preserved a
critical defense capability. The remainder was associated with the acquiring
company’s existing contracts or new contracts awarded after the
acquisition-costs DOD has historically paid.

In testimony before the Senate Committee on Armed Services, Subcommittee on
Acquisition and Technology, the Director, Defense Procurement, identified two
instances-the Advanced Medium Range Air-to-Air Missile (AMRAAM) and the
Bradley Fighting Vehicle-in which DOD believes that restructuring resulted in
contract price reductions.’ The Director noted, however, that DOD had
maintained a competition between the two companies that produced the
AMRAAM, so it was difficult to isolate the impact of restructuring activities.
Nonetheless, the Director believed that overhead rates have been reduced as a
result of cost savings from mergers and acquisitions.

Concerning the Bradley Fighting Vehicle, we previously attempted to identify
lower contract unit prices as a result of restructuring at the United Defense,
Limited Partnership, which manufactures the Bradley. At the time of our
review, DOD had awarded United Defense only one new contract that was
comparable to a contract awarded prior to restructuring. While we were unable
to determine the precise amount of restructuring savings on the contract, we
estimated 8 to 16 percent savings based on differences in projected number of
unim to be remanufactured and the inflation rate used to adjust the unit price of
the initial contract. We are attempting to find additional instances of lower
contract prices resulting from restructuring “savings.”

‘Hearina before the Subcommittee on Acauisition and Technolom, SenateCommittee on Am-ted
Services,Apr. 15, 1997.

Page 2                                             GAO/NSIAD-97-186R Restructuring   Savings
(3.)     Is the key premise behind which all of DOD’s claims of savings are
         based the idea that taxpayer reimbursement     for restructuring
         costs will cause defense contractors to restructure    sooner than
         they would otherwise?

While we believe this is a policy question best asked of DOD, three statements
made by senior DOD officials indicate that this is an important, if not the key,
premise. On July 27, 1994, the Deputy Secretary of Defense testified that strong
incentives for mergers and acquisitions already existed in the defense industry;
however, the issue remained as to whether the resulting restructuring would
happen sooner or later.2 The Deputy Secretary indicated that the longer a
restructuring was delayed, the more U.S. taxpayers would pay for a less
efficient operation. The Deputy Secretary also indicated that DOD’s
restructuring policy was encouraging a rational downsizing in the defense
industry and would ensure that taxpayers would receive cost savings as a result.
The Under Secretary of Defense (Acquisition and Technology) expressed a
similar view in a January 27, 1997, letter to Representative Christopher Smith.
In this letter, the Under Secretary stated that DOD’s decision to reimburse
contractors for certain restructuring-related expenses was based on the
assumption that by paying its share of restructuring costs, DOD would pay less
for the goods and services it buys because companies would restructure a year
or two sooner. The Secretary of Defense reiterated this position in a March 17,
1997, letter to Representative Smith.

(4)      Do DOD’s savings estimates used in the certification    process rely
         entirely on the assumption   that everything else, but for the
         restructuring, will remain the same after a business combination as
         before? What other factors that affect contract prices normally

The initial estimate of restructuring savings assumes that everything else, except
for the restructuring, is the same after a business combination as before. As
DOD’s December 1996 report to Congress stated, other factors, such as
inflation, business fluctuations, accounting system changes, subsequent
reorganizations, and unexpected events also affect actual costs.

Such factors can have a significant impact on the amount of savings achieved.
For example, the certified savings for one business combination we reviewed
was-about $111 million3 The contractor provided DOD quarterly reports to
demonstrate the actual savings realized. These reports provided such

“Hearinn before the Subcommittee on Oversight and Investigations. House Committee on Armed
Services,July 27, 1994.

“DOD does not reimburse a contractor for restructuring costs until the contractor’s restructuring
proposalis audited by DCAA and a high-level DOD official certifies that projected savingsshould
result in reduced overall costs to DOD.

Page 3                                                  GAO/NSIAD-97-186R Restructuring     Savings
information as baseline and current headcounts, and based savings on the
resulting difference multiplied by the labor and fringe benefit costs. This
approach produced savings estimates to within 5 percent of the certified
amount, but gave no consideration to changes in the business base that
occurred during the restructuring. However, when DCAA considered such
factors as changes in the business base, differences in where certain work was
accomplished, and the stretch-out of other work, it estimated that actual savings
were less than two-thirds of the certified amount.

(5)      How significant    are employee layoffs        in DOD’s estimates       of

The savings resulting from employee layoffs constitute a significant element of
DOD’s estimates of savings. Using information on the nature of savings from
four of the five business combinations included in our April 1, 1997, report,4 we
estimated that the savings attributed to the salaries and benefits avoided by
laying off workers were the largest single category of certified savings, about 48
percent of the certified savings for these 4 business combinations. The amount
of savings due to laying off workers varied among contractors due to the Qpe
of restructuring undertaken. For the 4 restructurings, the certified savings
attributable to lay-offs varied from 8 to 100 percent.

(6)      When calculating its estimates of savings, does DOD assume that
         such savings are recurring in nature? Given that DOD has said
         that restructuring   payments are designed to move up mergers and
         acquisitions   by a year or two, what would be the effect on DOD’s
         estimates of savings of counting them for two years as opposed to
         the maximum of five years that is the current practice?

Defense contractors used various methodologies for savings and cost estimates,
which DOD certifies after DC&4 audits. In some cases, the contractor prepared
estimates based on the projected impact in one year and then simply multiplied
the resulting figure by five-the maximum number of years over which DOD
allows savings to be counted. In other cases, the contractor attempted to
estimate the savings for each year individually. In either case, however, limiting
the period for counting savings to the first 2 years, rather than the 5 years
currently allowed, would have a significant impact on the amount of certified
savings. For combinations that used a single, recurring figure, limiting the
savings to 2 years for certification purposes would reduce the amount of
certified savings by 60 percent. For combinations that attempted to discretely
estimate restructuring savings, the impact would vary. For example, for one
business combination we reviewed, limiting the period to the first 2 years would

?he fifth combination was unable to provide us such information due to the methodology used to
calculate savings.

Page 4                                               GAONXAD-97-186R Restructuring Savings
reduce the certified savings by almost 80 percent, provided the restructuring
still took place.

(7)      What would have been the effect of legislation     disallowing  the
         recoupment of restructuring costs, had it been enacted, on the
         additional costs to DOD as a result of its July 1993 decision to pay
         for restructuring  costs on flexibly-priced contracts transferred
         from one company to another after a business combination?

The DCAA estimated that $18 million-or about 10 percent of the $179.2 million
that DOD had paid for restructuring costs as of September 1996-was charged
to flexibly priced contracts transferred after business combinations. Had DOD
maintained its long-standing practice of not reimbursing contractors for
restructuring costs on these contracts, then DOD would not have paid the $18
million, assuming that the business combinations and the subsequent
restructurings would have occurred in the same manner and in the same time

(8)      Given the difficulties  inherent in estimating savings due to
         payment of restructuring     costs, what would GAO recommend with
         respect to the continuation    of mandated reporting  requirements
         for DOD, which will expire this year?

During our April 15 testimony before the Subcommittee on Acquisition and
Technology, Senate Committee on Armed Services, we suggested that Congress
may wish to consider extending, at least for the short term, that reporting
requirement to provide further visibility into the actual savings resulting from
restructuring activities.

It should also be noted that in our April 1997 report, we identified about $48
million in federal grants administered by the Department of Labor that were
provided either directly to defense contractors involved in business
combinations or to locations where workers were laid off as a result of the
business combinations or normal downsizing. These grant funds were provided
to assist laid-off workers find new employment. Because these grant funds can
be substantial, we recommended that the Secretary of Defense obtain
information about such grants and include this information in DOD’s annual
report to Congress. DOD officials indicated that they would meet with
Department of Labor officials to determine how information on the amount of
such grants could be made available to DOD for inclusion in its annual report to

In preparing this letter, we relied primarily on our work over the past 3 years.
We will provide copies of this letter to the Secretaries of Defense and Labor;
the Commander, Defense Contract Management Command; the Director,
Page 5                                       GAOINSIAD-97-186R Restructuring   Savings

Defense Contract Audit Agency; the Director, Office of Management and Budget;
and interested congressional committees. Copies will also be made available to
others upon request.

If you have any questions, please contract me at (202) 512-4841. The principal
contributors to this letter were John K. Harper, George C. Burdette, Timothy J.

David E. Cooper
Associate Director
Defense Acquisitions Issues

Page 6                                       GAO/NSIAD-97-186R Restructuring   Savings
                       LIST   OF RELATED     REPORTS

Defense Industrv Restructuring: Cost and Savings Issues (GAO/T-NSIAD-97-141,
Apr. 15, 1997).

Defense Restructurhw Costs: Information Pertaining to Five Business
Combinations (GAO/NSLAD-97-97, Apr. 1, 1997).

Defense Restructuring Costs: Proiected and Actual Sax-innsFrom Martin
Marietta Acauisition of GE Aerowace (GAO/NSIAD-96-191, Sept. 5, 1996).

Defense Contractor Restructuring: First ADDlication of Cost and Savinns
Regulations (GAO/NSKD-96-80, Apr. 10, 1996).

Defense Restructuring Costs: Pavment Retiations    are Inconsistent With
LeTislation (GAOINSIAD-95-106, Aug. 10, 1995).

Defense Industrv Consolidation: Issues Related to Acauisition and Merger
Restructuring: Costs (GAO/T-NSJAD-94-247,July 27, 1994).


Page 7                                      GAO/NSIAD-97-186R Restructuring   Savings
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