oversight

Defense Working Capital Funds: DOD Faces Continued Challenges in Eliminating Advance Billing

Published by the Government Accountability Office on 1997-07-22.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Military Readiness,
                          Committee on National Security, House of Representatives




For Release on Delivery
Expected at
2 p.m.
                          DEFENSE WORKING
Tuesday,
July 22, 1997             CAPITAL FUNDS

                          DOD Faces Continued
                          Challenges in Eliminating
                          Advance Billing
                          Statement of Jack L. Brock, Jr.
                          Director, Defense Information and Financial Management
                          Systems
                          Accounting and Information Management Division




GAO/T-AIMD/NSIAD-97-221
                  Mr. Chairman and Members of the Subcommittee:

                  We are pleased to be here today to discuss the Department of Defense’s
                  (DOD) working capital funds, formerly known as the Defense Business
                  Operations Fund (DBOF), which both collect and disburse over $65 billion
                  annually. Specifically, our testimony will provide a (1) brief overview of
                  fund operations and objectives, (2) a more detailed perspective of cash
                  management operations, and (3) our concerns with the cash situation
                  through fiscal year 1998.


                  In 1991, the Department established DBOF in order to foster a more
Working Capital   business-like culture within selected Defense operations—including depot
Funds             maintenance, transportation, supply management, and finance and
                  accounting. In creating DBOF, DOD consolidated the nine existing industrial
                  and stock funds operated by the military services and Defense
                  components into a single financial structure. The military services and
                  Defense components continued to be responsible for managing and
                  operating business activities within the financial structure. In late 1996, the
                  Under Secretary of Defense (Comptroller) reorganized DBOF and created
                  four working capital funds: Army, Navy, Air Force, and Defense-wide. This
                  was done in order to clearly delineate the responsibilities of the military
                  services and Defense components for managing the functional and
                  financial aspects of their respective business areas. The recently
                  established working capital funds continue to operate the same way they
                  did under DBOF.

                  The primary goal of the working capital funds is to focus the attention of
                  all levels of management on the total costs of carrying out certain critical
                  DOD business operations and the management of those costs in order to
                  encourage support organizations, such as depot maintenance facilities, to
                  provide quality goods and services at the lowest costs. Focusing attention
                  on costs is important, given the size of the working capital funds. For
                  fiscal year 1998, the four funds are expected to generate about $69 billion
                  in revenue and employ about 220,000 civilians and 24,000 military
                  personnel.

                  The working capital funds are supposed to generate sufficient revenues to
                  recover expenses incurred in their operations and to operate on a
                  break-even basis over time. Essentially, each business area establishes
                  prices prior to the start of each fiscal year and applies these
                  predetermined (stabilized) prices to most orders and requisitions received



                  Page 1                                                 GAO/T-AIMD/NSIAD-97-221
                       during the year. Prices reflect expected workload (based on customer
                       input), costs of labor and material, and productivity projections. To the
                       extent these estimates are accurate, revenues should cover cost.
                       Higher-than-expected costs or lower demand can lead to losses while the
                       converse can lead to profits. Since the funds are to operate on a
                       break-even basis over time, profits effectively reduce prices in later years
                       while losses result in higher prices or surcharges.

                       To date, the working capital funds have not yet accomplished their goal of
                       operating on a break-even basis and DOD estimates that they will have an
                       accumulated operating loss of $1.7 billion at the end of fiscal year 1997.
                       Over the last several years, various congressional Defense oversight and
                       appropriations committees have expressed concern with these losses and
                       the management and operations of the funds. To address these concerns,
                       Defense was required to conduct a study of its working capital funds as
                       directed in the National Defense Authorization Act for Fiscal Year 1997.
                       Not later than September 30, 1997, the Secretary of Defense is required to
                       submit to the Congress a plan to improve the management and
                       performance of the industrial, commercial, and support type activities that
                       are currently managed in the working capital funds.

                       We remain very supportive of the concept behind the working capital
                       funds. We believe the funds, even under DBOF, have achieved a measure of
                       success because they are doing a better job of identifying the costs of
                       doing business and including those costs in the prices charged to
                       customers. This gives DOD managers a window into the costs of Defense
                       support operations—including costs for direct labor, material, overhead,
                       and contracts. With a more complete cost picture, managers can account
                       for past activities, manage current operations, and assess progress toward
                       planned objectives. In addition, more accurate identification of costs
                       enables those responsible for providing oversight to make more informed
                       policy decisions by highlighting the cost associated with those decisions.
                       We are hopeful that DOD will use its forthcoming plan as a mechanism to
                       continue to strengthen its commitment to improving the management and
                       operations of the working capital funds as well as identifying the total
                       costs of providing goods and services to customers and including those
                       costs in the prices charged customers.


                       Since 1993, the working capital funds have experienced a cash shortage
Working Capital Fund   and have had to advance bill customers for work not yet performed in
Cash Management        order to ensure that the funds’ cash balances remain positive. In



                       Page 2                                                GAO/T-AIMD/NSIAD-97-221
                            February 1995, DOD devolved the responsibility for cash management to
                            the military services and the Defense components to better align
                            accountability and responsibility for management; however, advance
                            billing continues and may well continue through the next fiscal year.


The Importance of Cash      Cash plays an extremely important role for DOD’s working capital funds.
for Working Capital Funds   Cash generated from the sale of goods and services is the primary means
                            by which the working capital funds pay their bills. Where the cash
                            balances start each year depends on the outcome of many decisions made
                            during the budget process with regard to (1) projecting workload,
                            (2) estimating costs, and (3) setting prices to recover the estimated full
                            cost of the goods and services. During the execution of the budget, they
                            operate much like a checking account: collections increase the funds’
                            account balances and disbursements (such as salaries and purchases of
                            inventory) reduce the account balances. To the extent that the decisions
                            made during the budget process are reasonably accurate, the funds’ cash
                            balances should fall between the minimum and maximum amount required
                            by DOD. However, if the decisions are not accurate, the funds could have
                            too much or not enough cash.

                            DOD’s policy requires the funds to maintain cash levels to cover 7 to 10
                            days of operational costs and 4 to 6 months of capital asset disbursements,
                            which is about $2.3 billion to $3.4 billion for the four funds. If the level of
                            cash becomes low and there is a possibility of incurring an Antideficiency
                            Act1 violation, immediate actions will be taken to resolve the cash
                            shortages by advance billing customers.

                            When DBOF was established, DOD consolidated the cash balances of the
                            nine industrial and stock funds into a single account that was managed
                            centrally by the Office of the Secretary of Defense (Comptroller). DOD
                            believed that managing cash at a central level would be more effective.
                            However, in practice this did not work as expected, and, in February 1995,
                            DOD devolved responsibility for cash management as well as Antideficiency
                            Act responsibilities to the military services and the Defense components.
                            According to DOD officials, the cash management responsibility was
                            devolved to the Army, Navy, Air Force, and Defense components to better
                            align accountability and responsibility for managing cash. DOD pointed out
                            that the operational control of actions taken by each fund activity, which


                            1
                             The Antideficiency Act, 31 U.S.C. 1341(a)(1) provides that no officer or employee of the government
                            shall make or authorize an expenditure or obligation exceeding the amount of an appropriation of
                            funds available for the expenditure or obligation.



                            Page 3                                                                 GAO/T-AIMD/NSIAD-97-221
                             results in cash disbursements and collections, always has resided and
                             continues to reside with the individual Defense components.

                             We agree with DOD’s decision to place the responsibility for managing the
                             working capital funds’ cash at the military service and Defense component
                             level and to likewise devolve the Antideficiency Act responsibility.
                             Decentralized cash management should result in a number of benefits. For
                             example:

                         •   Decentralization makes each individual Defense component directly
                             accountable for its respective cash balance as well as its decisions that
                             affect cash, including any violation of the Antideficiency Act. Each
                             component now has an incentive to more accurately price the goods and
                             services that its working capital fund charges customers since inaccurate
                             prices could lead to insufficient cash to cover daily operating expenses.
                         •   One Defense component cannot spend money generated by another
                             component. When cash management was centralized, DOD did not have
                             reports that showed the cash balances for the individual Defense
                             components—the reports only provided information on (1) DBOF’s overall
                             cash balance and (2) collection and disbursement data for each of the
                             Defense components. With the decentralization of cash management, the
                             Department of the Treasury provides DOD with a cash balance for each of
                             the five components.
                         •   The Office of the Secretary of Defense (OSD) and the Defense components
                             have started working more as a team to resolve cash problems. Under
                             centralized cash management, there was less incentive for the components
                             to respond to cash problems as OSD had responsibility for maintaining the
                             balance and for avoiding an Antideficiency Act violation. When the
                             components became responsible for their individual cash balances, they
                             raised more questions on the accuracy and timeliness of the information
                             on collections and disbursements. Such increased attention should help
                             improve the accuracy of collection and disbursement data reported in the
                             working capital funds’ financial statements prepared under the Chief
                             Financial Officers Act of 1990, as expanded by the Government
                             Management Reform Act of 1994.2


DOD Has Advance Billed       Since 1993—with the transfer of $5.5 billion from DBOF as required by the
Customers to Alleviate       National Defense Authorization Act for Fiscal Year 1993—the funds have
Cash Shortages               been advance billing customers because they have not been able to

                             2
                              Since the inception of DBOF in fiscal year 1992, the DOD Inspector General has not been able to
                             render a favorable audit opinion on the fund’s financial statements.



                             Page 4                                                                 GAO/T-AIMD/NSIAD-97-221
generate enough cash to pay their bills. In July 1994, the Comptroller of
Defense stopped the advance billing at all activities except for the Naval
shipyards and research and development activities, which had been
tentatively scheduled to stop advance billing in January 1995. However,
DOD officials informed us that when the responsibility for cash
management was returned to the components in February 1995, the
amount of cash returned to the services was not sufficient to cover
outstanding DBOF liabilities. DBOF’s financial reports indicate that this was
the case with each service facing cash shortages. Therefore, according to
DOD, it was necessary for the Army, Navy, and Air Force to continue to
advance bill customers so that their cash portion of DBOF would not go
negative.

Since 1995, the military services have made some progress in liquidating
(working off) their outstanding advance billing balances. However, the
Navy and Air Force had to advance bill customers again during calendar
years 1996 and 1997 to ensure that their cash balances remained positive.
Specifically, the Navy advance billed customers about $1.7 billion and the
Air Force advance billed customers $1.2 billion during calendar year 1996.
For calendar year 1997, the Navy and Air Force have advance billed their
customers about $400 million and $695 million, respectively, with most of
the billings occurring in June 1997—$230 million for the Navy and
$565 million for the Air Force. Figure 1 shows (1) the reported cash
balances for the Army, Navy, and Air Force portions of the funds and
(2) cash balances for these components if they did not advance bill their
customers from February 1995—when DOD returned the responsibility for
cash to the military services and Defense components—through May 1997
(the charts in figure 1 only depict data through May 1997 because working
capital fund outstanding advance billing balance data for June 1997 were
not yet available). (The charts in figure 1 are also provided in full-page
view in appendix I.)




Page 5                                                 GAO/T-AIMD/NSIAD-97-221
Figure 1: Working Capital Fund Cash Balances (Dollars in Millions)

Overall Working Capital Fund                                                                                                Army Working Capital Fund




 6,000                                                                                                800                                                                    Cash balance
                                                                      Cash balance

 5,000                                                                    W/O adv. bill.              600                                                                    W/O adv. bill.

 4,000
                                                                                                      400
 3,000
                                                                                                      200
 2,000
                                                                                                         0
 1,000
                                                                                                     -200
      0

-1,000                                                                                               -400
          2/95    6/95                           6/96      12/96   5/97                                      2/95        6/95                      6/96          12/96    5/97
Cash policy requires about $2.3 billion to $3.4 billion.                                             Cash policy requires about $360 million to $515 million.




Navy Working Capital Fund                                                                                           Air Force Working Capital Fund




 3,000                                                                    Cash balance                1,200                                                                      Cash balance

                                                                          W/O adv. bill.              1,000
 2,000                                                                                                                                                                            W/O adv. bill.
                                                                                                         800
 1,000
                                                                                                         600
      0                                                                                                  400

                                                                                                         200
-1,000
                                                                                                              0
-2,000
                                                                                                        -200
-3,000                                                                                                  -400
          2/95    6/95                           6/96      12/96   5/97                                           2/95     6/95                      6/96         12/96    5/97
Cash policy requires about $625 million to $900 million.                                              Cash policy requires about $465 million to $670 million.




                                                                              Note: We did not independently verify the financial information shown in the figure, which was
                                                                              taken from DOD and Treasury reports.




                                                                              Page 6                                                                                        GAO/T-AIMD/NSIAD-97-221
                              As figure 1 shows, the Army, Navy and Air Force would have had negative
                              cash balances when they received the responsibility for cash in
                              February 1995 had they not advance billed customers. The figure also
                              shows the following.

                          •   The three military services have liquidated $4.2 billion of outstanding
                              advance billings from February 1995 through May 1997. However, because
                              of Navy and Air Force advance billings in June 1997, we are unsure of the
                              effect these billings will have on the liquidation on the outstanding
                              advance billings to date.
                          •   As of May 1997, the outstanding advance billing balance was about
                              $1 billion. Again, because of Navy and Air Force advance billings in
                              June 1997, we are unsure of the effect these billings will have on the
                              outstanding advance billing balances to date.
                          •   The Army has liquidated almost all of its outstanding advance billing
                              balance.
                          •   The Navy’s cash balance would have been negative for most of the period
                              from February 1995 through May 1997 if it had not advance billed
                              customers.
                          •   The Air Force liquidated most of its outstanding advance billing balance
                              until it again started advance billing customers over a billion dollars in
                              December 1996 to ensure that its cash balance would remain positive.

                              According to Army and Air Force officials, they plan to liquidate all their
                              outstanding advance billing balances by the end of fiscal year 1998. Navy
                              officials informed us that they now plan to liquidate the Navy’s
                              outstanding advance billing balance by the end of fiscal year 1999.


Cash Outlook for Fiscal       DOD’s cash plans, dated January/February 1997, show that the working
Years 1997 and 1998           capital funds will disburse about $2.3 billion more than they collect during
                              fiscal year 1997. To offset most of the cash drain that DOD expects to occur
                              during fiscal year 1997, DOD plans to increase fiscal year 1998 prices to
                              recoup losses and generate cash. DOD plans also show that it expects to
                              collect about $2.2 billion more than it disburses during fiscal year 1998.
                              This information is summarized in table 1.




                              Page 7                                                GAO/T-AIMD/NSIAD-97-221
Table 1: DOD’s Working Capital Fund
Annual Cash Plans Dated               Dollars in millions
January/February 1997                                                                 Estimated fiscal year Estimated fiscal year
                                                                                      1997 collections less 1998 collections less
                                      Component                                             disbursements         disbursements
                                      Army                                                           $ (173.4)                   $ 27.2
                                      Navy                                                           (1,427.7)                   984.5
                                                a
                                      Air Force                                                        (154.5)                   493.4
                                      Defense agencies                                                 (511.0)                   669.4
                                      Total                                                         $(2,266.6)                 $2,174.5
                                      a
                                       Air Force fiscal year 1998 figure includes United States Transportation Command’s net
                                      collections of $102.6 million.



                                      Based on our analysis of cash and outstanding advance billing balances, as
                                      well as past trends, we believe that the Navy and Army may have to
                                      advance bill customers during the remainder of fiscal year 1997 in order to
                                      ensure that their cash balances remain positive. This is primarily because
                                      these services’ recently reported cash balances are below the minimum
                                      required cash level.

                                      Further, as we have previously testified,3 our review of five working
                                      capital fund business areas and the assumptions used to develop their
                                      fiscal year 1998 prices (which could change as fiscal year 1998
                                      approaches) indicated that the prices for four of the five business areas
                                      may not be high enough to cover estimated fiscal year 1998 operating costs
                                      and eliminate accumulated operating losses by over $300 million. In
                                      developing their fiscal year 1998 prices, our review showed that the
                                      business areas (1) overestimated productivity, (2) set unrealistic
                                      cost-reduction goals, and (3) overestimated workload.

                                      These problems are not unique to the development of the fiscal year 1998
                                      prices. We have previously reported4 that these problems have been the
                                      primary cause of some business areas reporting operational losses. Until
                                      DOD acts to resolve these problems, some business areas will continue to
                                      incur losses from day-to-day operations, which could impede DOD’s ability
                                      to eliminate the practice of advance billing.

                                      3
                                       Defense Depot Maintenance: Challenges Facing DOD in Managing Working Capital Funds
                                      (GAO/T-NSIAD/AIMD-97-152, May 7, 1997).
                                      4
                                       Air Force Depot Maintenance: Improved Pricing and Financial Management Practices Needed
                                      (GAO/AFMD-93-5, Nov. 17, 1992); Defense Business Operations Fund: Improved Pricing Practices and
                                      Financial Reports Are Needed to Set Accurate Prices (GAO/AIMD-94-132, June 22, 1994); and Navy
                                      Ordnance: Analysis of Business Area Price Increases and Financial Losses (GAO/AIMD/NSIAD-97-74,
                                      Mar. 14, 1997).



                                      Page 8                                                               GAO/T-AIMD/NSIAD-97-221
Mr. Chairman, this concludes our statement. We would be pleased to
answer any questions you or Members of the Subcommittee may have at
this time.




Page 9                                          GAO/T-AIMD/NSIAD-97-221
Working Capital Fund Cash Balances
(Dollars in Millions)


Figure I.1: Overall Working Capital Fund

6,000                                                                                                              Cash balance

                                                                                                                   W/O adv. bill.
5,000


4,000


3,000


2,000


1,000


    0


-1,000
         2/95      6/95                                       6/96                    12/96                 5/97

                                           Note: Cash policy requires about $2.3 billion to $3.4 billion.




                                           Page 10                                                                  GAO/T-AIMD/NSIAD-97-221
                                        Working Capital Fund Cash Balances
                                        (Dollars in Millions)




Figure I.2: Army Working Capital Fund


800                                                                                                      Cash balance

                                                                                                         W/O adv. bill.
600



400



200



   0



-200



-400
       2/95       6/95                                   6/96                  12/96              5/97

                                        Note: Cash policy requires about $360 million to $515 million.




                                        Page 11                                                            GAO/T-AIMD/NSIAD-97-221
                                        Working Capital Fund Cash Balances
                                        (Dollars in Millions)




Figure I.3: Navy Working Capital Fund


3,000                                                                                                    Cash balance

                                                                                                         W/O adv. bill.
2,000



1,000



     0



-1,000



-2,000



-3,000
         2/95      6/95                                   6/96                  12/96            5/97

                                        Note: Cash policy requires about $625 million to $900 million.




                                        Page 12                                                            GAO/T-AIMD/NSIAD-97-221
                                             Working Capital Fund Cash Balances
                                             (Dollars in Millions)




Figure I.4: Air Force Working Capital Fund

1,200                                                                                                          Cash balance

1,000                                                                                                          W/O adv. bill.


  800


  600


  400


  200


      0


 -200


 -400
          2/95      6/95                                       6/96                  12/96              5/97

                                             Note: Cash policy requires about $465 million to $670 million.




(511633, 709289)                             Page 13                                                             GAO/T-AIMD/NSIAD-97-221
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