oversight

Navy Ordnance: Analysis of Business Area Price Increases and Financial Losses

Published by the Government Accountability Office on 1997-03-14.

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

                       United States General Accounting Office

GAO                    Report to the Chairman of the
                       Subcommittee on Military Readiness,
                       Committee on National Security,
                       House of Representatives

March 1997
                       NAVY ORDNANCE
                       Analysis of Business
                       Area Price Increases
                       and Financial Losses




GAO/AIMD/NSIAD-97-74
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Accounting and Information
      Management Division

      B-274841

      March 14, 1997

      The Honorable Herbert H. Bateman
      Chairman, Subcommittee on Military Readiness
      Committee on National Security
      House of Representatives

      Dear Mr. Chairman:

      This report responds to your request that we review financial and operational management
      issues relating to the Navy ordnance business area which was included in the Defense Business
      Operations Fund (DBOF). On December 11, 1996, the Under Secretary of Defense (Comptroller)
      reorganized DBOF and created four working capital funds: Army, Navy, Air Force, and
      Defense-wide. The Navy ordnance business area is now part of the Navy Working Capital Fund.
      The four working capital funds will continue to operate under the revolving fund concept and
      charge customers the full costs of providing goods and services to them. Since the Navy
      ordnance business area still operates under the revolving fund concept, our findings and
      recommendations are applicable under the working capital fund structure.

      The financial information on the operation of this business area shows that there are several
      key reasons for about $212 million of reported losses experienced from fiscal year 1994 through
      fiscal year 1996. In particular, most of these losses were attributable to actual overhead costs
      exceeding budgeted overhead costs. This situation has caused significant price increases that
      ultimately result in reduced purchasing power for the military services’ operations and
      maintenance appropriation dollars. We are concerned that excessive operating costs may exist
      in many of the Department of Defense’s (DOD) logistics business activities and may be causing
      substantial amounts of operation and maintenance appropriations to be used inefficiently. As
      discussed with your office, we will be looking at additional DOD business activities to determine
      the extent of this problem.

      We are sending copies of this report to the Ranking Minority Member of your Subcommittee;
      the Chairmen and Ranking Minority Members of the Senate Committee on Armed Services; the
      Senate Committee on Appropriations, Subcommittee on Defense; the House Committee on
      Appropriations, Subcommittee on National Security; the Senate and House Committees on the
      Budget; the Secretary of Defense; the Secretary of the Navy; and the Director of the Defense
      Finance and Accounting Service. Copies will also be made available to others upon request.
B-274841

If you have any questions about this report, please call Greg Pugnetti at (202) 512-6240. Other
major contributors to this report are listed in appendix II.

Sincerely yours,




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




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




                     Page 2                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
B-274841




           Page 3   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary


             The Chairman, Subcommittee on Military Readiness, House Committee on
Purpose      National Security, asked us to determine why the Navy ordnance business
             area increased prices 78 percent from fiscal years 1994 through 1996 and
             incurred about $212 million in losses during that 3-year period. The
             Chairman also asked us to determine whether management has accurate
             and consistent financial management information for effectively managing
             the Navy ordnance business area.

             On December 11, 1996, the Under Secretary of Defense (Comptroller)
             reorganized DBOF and created four working capital funds: Army, Navy, Air
             Force, and Defense-wide. The Navy ordnance business area is now part of
             the Navy Working Capital Fund. The four working capital funds will
             continue to operate under the revolving fund concept—using the same
             policies, procedures, and systems as they did under DBOF—and charge
             customers the full costs of providing goods and services to them. The
             Comptroller made this change to clearly establish the military services’
             and DOD components’ responsibilities for managing the functional and
             financial aspects of the business areas.


             The Navy ordnance business area provides various services, including
Background   ammunition storage and distribution as well as the maintenance of
             missiles, to customers who consist primarily of Defense organizations but
             also include foreign governments. During fiscal year 1996, the business
             area sold about $563 million of services to its customers—primarily
             commands and activities of the military services. For financing purposes,
             the business area is part of the Navy Working Capital Fund, which is a
             revolving fund that relies on sales revenue rather than direct congressional
             appropriations to finance its operations. Revolving funds are supposed to
             generate sufficient revenues to cover the expenses incurred in their
             operations. In fact, the revolving funds are expected to operate on a
             break-even basis over time—that is, not to make a profit nor incur a loss,
             but simply to recover all costs.

             The Navy ordnance business area generates revenue by billing customers
             at predetermined prices as it performs specifically agreed upon work for
             those customers. The prices are to be based upon anticipated actual costs.
             Customers primarily use operations and maintenance appropriations to
             pay for this work. Payments from customers replenish the Navy Working
             Capital Fund’s working capital, which is used to finance subsequent
             operations. The ordnance business area is expected to operate within the
             revenue it generates. Conceptually, this provides an incentive to control



             Page 4                                    GAO/AIMD/NSIAD-97-74 Navy Ordnance
                   Executive Summary




                   costs and maximize efficiency. It is essential that the business area operate
                   efficiently since every dollar spent on the Navy Working Capital Fund’s
                   infrastructure is one less dollar available for other defense spending
                   priorities.


                   The business area’s price increased from $50.02 per direct labor hour in
Results in Brief   fiscal year 1994 to $89.03 per direct labor hour in fiscal year 1996—a 78
                   percent increase. A large part of this price increase was due to the
                   inclusion of significant overhead costs in the prices charged
                   customers—costs that were previously paid for through direct
                   appropriations or by Navy major commands. Even though the prices
                   increased, the business area reported it lost about $212 million during
                   fiscal years 1994 through 1996, and would have lost more if it had not been
                   allowed to increase its prices in order to recoup prior year losses. These
                   losses primarily occurred because (1) actual overhead costs that the
                   business area was responsible for exceeded budget projections and (2) the
                   business area received lower-than-expected workload levels which
                   prevented it from generating enough revenue to recover its budgeted
                   overhead costs. These rising prices and consistent losses ultimately reduce
                   the purchasing power of the customers’ appropriations.

                   The Navy’s implementation of DBOF and its reorganization to consolidate
                   ordnance functions have resulted in more costs being identified and
                   included in the prices charged customers. This has helped to identify areas
                   of inefficient operations within the business area that contribute to the
                   price increases—principally overhead costs. However, the Navy ordnance
                   business area still needs to take a number of actions to ensure that
                   accurate and consistent information is available to effectively manage the
                   business operations. Specifically, we found that the business area (1) did
                   not accurately forecast the amount of work to be performed, (2) used a
                   pricing structure that did not allow individual ordnance activities to
                   charge prices that represented their estimated cost of doing business, and
                   (3) did not accurately budget and account for costs.




                   Page 5                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                            Executive Summary




Principal Findings

Factors Contributing to                     The Navy ordnance business area’s composite sales price1 increased from
Price Increases                             $50.02 per direct labor hour (DLH) in fiscal year 1994 to $89.03 per DLH in
                                            fiscal year 1996. We found that

                                        •   $15.25, or 39.1 percent, of the per hour increase was due to efforts to
                                            ensure that prices more accurately reflect the full costs of the Navy
                                            ordnance operations;
                                        •   $13.79, or 35.3 percent, of the per hour increase was attributable to DOD’s
                                            policy that requires prices to be adjusted to recover prior year losses or
                                            return profits (most prior year losses occurred because actual overhead
                                            costs exceeded budgeted overhead costs);
                                        •   $5.46, or 14.0 percent, of the per hour increase stemmed from overhead
                                            costs being allocated over a declining workload; and
                                        •   $4.51, or 11.6 percent, of the per hour increase was due to increases in
                                            direct labor costs.

                                            Figure 1 illustrates the percentage of price increases by category.



Figure 1: Factors Contributing to Price Increases

                                                            Full costs     39.1%




  Loss policy   35.3%                                                              Labor costs      11.6%




                                                              Overhead        14.0%



                                            1
                                             The composite sales price is the average amount that customers must pay for a direct labor hour.



                                            Page 6                                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary




In developing the fiscal year 1996 prices, the Navy ordnance business area
did a better job of identifying the total costs of its operations and factoring
those costs into the prices. Specifically, in determining fiscal year 1996
prices, the Navy identified and included about $87 million of estimated
costs that were not included in fiscal year 1994 prices. These were costs
incurred for military security guards, headquarters personnel, and
underutilized plant capacity. By including these additional costs in the
prices, the business area is now in a better position to identify the full
costs of its operations. Only through the identification of the full costs of
operations can management—DOD and the Navy—begin to make more
informed decisions on the appropriate action needed to reduce
infrastructure costs.

Also, in accordance with DOD’s policy, the Navy ordnance business area
increased fiscal year 1995 and 1996 prices to recover prior years’ operating
losses. Navy ordnance officials stated that DOD’s policy causes major price
fluctuations from one year to the next and drives some customers to seek
other sources for the work. To illustrate the potential magnitude and
impact of this problem, they pointed out that the estimated accumulated
loss at the end of fiscal year 1997 is expected to be about $220 million. To
recoup this loss within a year, the Navy could (1) add $49 an hour to the
fiscal year 1998 prices—a 60-percent increase over the fiscal year 1997
prices—or (2) request a direct appropriation of $220 million. DOD and the
Navy decided to increase the prices charged customers for ammunition
storage and distribution to recover these losses.

Further, because customers are ordering less work, the Navy ordnance
business area is allocating its overhead costs over a continually declining
workload base. From fiscal year 1994 through fiscal year 1996, the number
of budgeted DLHs decreased from 6.9 million to 5.7 million—a 17 percent
decrease. During this same period, the business area’s actual overhead
costs did not decrease proportionately with the decline in workload. As a
result, more overhead costs are being allocated to each direct hour. This
operating environment of declining workload and increasing prices is one
of the most critical challenges DOD currently faces. Three years ago, the
Under Secretary of Defense (Comptroller) referred to this environment as
a “vicious circle” and said it was the single largest threat to DBOF.
According to the Comptroller, DOD’s inability to reduce infrastructure costs
as fast as customer budgets are being reduced is at the center of the
dilemma. Since customers are paying higher prices for needed goods and
services and they have a finite amount of funds, their overall demand for
work is decreasing.



Page 7                                      GAO/AIMD/NSIAD-97-74 Navy Ordnance
                          Executive Summary




Factors Contributing to   The Navy ordnance business area reported losses of about $212 million for
Losses                    fiscal years 1994 through 1996 and would have lost more had it not added
                          surcharges to its fiscal year 1995 and 1996 prices. These losses can be
                          attributed to several factors, but they primarily resulted from overhead
                          costs exceeding budget projections. In fact, the actual reported overhead
                          costs in fiscal years 1994 and 1995 were about $201 million higher than
                          budget estimates. According to GAO’s analysis and Navy ordnance officials,
                          these higher-than-expected overhead costs occurred because (1) DOD’s
                          pricing policy required the business area to absorb unanticipated cost
                          increases of at least $87 million, which were previously paid for by other
                          appropriations or major commands, and (2) the Navy ordnance business
                          area did not achieve savings goals that were incorporated into its budgets
                          by Navy and DOD budget officials.

                          Further, because prices charged customers are based on projected
                          workload, workload shortfalls adversely impacted the financial results of
                          the Navy ordnance business area. GAO’s analysis of budgeted and actual
                          DLHs for fiscal years 1994 and 1996 showed that the business area
                          performed about 900,000 fewer DLHs of work than it budgeted. The
                          lower-than-expected workload levels forced the business area to shift
                          many of its direct labor employees into overhead positions, and resulted in
                          not generating sufficient revenue to cover fixed overhead costs. The
                          workload shortfalls resulted in about $39.8 million in losses for the 2
                          years.

                          In addition, the Navy ordnance business area lost about $13 million related
                          to using Naval reserve forces to support its ordnance mission from fiscal
                          years 1994 through 1996. In accordance with DOD policy, the business area
                          bills customers for actual hours of work performed by the reserves but
                          reimburses the Reserve Personnel, Navy appropriation at the budgeted
                          amount. The budgeted hours should be based on realistic estimates of the
                          amount and type of work that the reserves will be able to accomplish.
                          However, the actual labor performed by the reserves for ordnance related
                          work was a reported $13 million less than the amount that the Navy
                          ordnance business area reimbursed the Reserve Personnel, Navy
                          appropriation.


Effective Management      While the Navy ordnance business area has improved the availability of
Requires More Accurate    information needed to manage the business area by including more of the
and Consistent            relevant costs in the prices charged customers, it still lacks accurate and
                          consistent information on the amount of work to be performed and the
Information


                          Page 8                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                  Executive Summary




                  cost of performing that work. This information is essential to a revolving
                  fund operation since (1) revenue is based on the amount of work
                  performed and the price charged for that work and (2) revenue should
                  approximate the cost of performing the work if the revolving fund is to
                  operate on a break-even basis.


                  We are making recommendations to the Secretary of Defense and the
Recommendations   Secretary of the Navy for improving the Navy ordnance business area’s
                  operations, price-setting, and financial management practices. These
                  recommendations focus on (1) the Navy developing a plan to streamline
                  the Navy ordnance operations and reduce its infrastructure costs,
                  including overhead, (2) setting prices based on realistic estimates of work
                  to be performed, (3) setting prices that are based on costs expected to be
                  incurred by individual Navy ordnance activities, and (4) ensuring that
                  costs, especially overhead costs, are accurately allocated to the customers
                  benefitting from the services.


                  In its written comments on this report, DOD stated that overall the report
Agency Comments   reasonably depicts the business activities of Navy ordnance and agreed
                  with three of our four recommendations. It did not agree at this time with
                  our recommendation on setting prices based on costs expected to be
                  incurred by individual activities. DOD cited the need to complete two
                  initiatives in order to more fully consider this recommendation. It expects
                  these initiatives to be completed by August 1, 1997. As part of the
                  congressionally mandated initiative to study working capital funds, DOD
                  indicated that it plans to evaluate the desirability of establishing individual
                  activity prices. As part of this evaluation, DOD needs to consider the
                  incentives that individual activities have for operating efficiently and
                  reducing costs.




                  Page 9                                      GAO/AIMD/NSIAD-97-74 Navy Ordnance
Contents



Executive Summary                                                                                4


Chapter 1                                                                                       12
                        Why Industrial Funds Were Established                                   12
Introduction            DOD Established DBOF                                                    13
                        Business Areas’ Budget and Price Setting Process                        15
                        Navy Established the Naval Ordnance Center                              15
                        Objectives, Scope, and Methodology                                      19

Chapter 2                                                                                       22
                        Current Prices More Accurately Reflect Total Cost of Operations         22
Factors Causing         Prior Year Losses Increase Sales Prices                                 24
Prices to Increase      Declining Workload Creates Pressure to Increase Prices                  24
                        Higher Prices Result in Customers Shifting Work From Navy               25
                          Ordnance Business Area
                        Conclusions                                                             27

Chapter 3                                                                                       28
                        Projected Operating Results Have Consistently Been Overly               28
Factors Contributing      Optimistic
to Navy Ordnance        Overhead Costs Have Been Much Higher-Than-Expected                      29
                        Lower-Than-Expected Workload Levels Also Contributed to the             33
Business Area Losses      Losses
                        Naval Reserve Units Have Not Provided Expected Level of                 34
                          Support
                        Conclusions                                                             35
                        Recommendations                                                         35
                        Agency Comments and Our Evaluation                                      36

Chapter 4                                                                                       37
                        More Reliable Workload Estimates Are Needed                             37
Effective Management    Uniform Price Structure Is Counterproductive to Efficient               39
and Oversight             Operations
                        Budgeting and Accounting for Overhead Costs Are Neither                 42
Requires Accurate         Accurate Nor Consistent
and Consistent          Conclusions                                                             44
Financial Information   Recommendations                                                         44
                        Agency Comments and Our Evaluation                                      45




                        Page 10                                  GAO/AIMD/NSIAD-97-74 Navy Ordnance
             Contents




Appendixes   Appendix I: Comments From the Department of Defense                   46
             Appendix II: Major Contributors to This Report                        50

Tables       Table 2.1: Major Causes of the Navy Ordnance Business Area’s          22
               Fiscal Year 1994-96 Sales Price Increase
             Table 2.2: Budgeted Overhead Costs and Direct Labor Hours for         25
               Fiscal Years 1994 and 1996
             Table 3.1: Navy Ordnance Business Area’s Budgeted and Actual          28
               Reported Operating Results for Fiscal Years 1994-96
             Table 3.2: Navy Ordnance Business Area’s Budgeted and Actual          30
               Reported Overhead Costs for Fiscal Years 1994-96
             Table 3.3: Losses Caused by Workload Shortfalls                       34
             Table 4.1: Comparison of Individual Weapons Station’s                 40
               Composite Price Per Hour to Overall NOC Composite Price for
               Fiscal Year 1996

Figures      Figure 1: Factors Contributing to Price Increases                      6
             Figure 1.1: Working Capital Fund Operations                           14
             Figure 1.2: Naval Ordnance Center Activities                          17
             Figure 1.3: Navy Ordnance Workload as a Percent of Revenue            18
             Figure 1.4: Navy Ordnance Workload                                    19
             Figure 3.1: Estimated vs. Actual Results                              29
             Figure 3.2: Estimated vs. Actual Overhead                             30




             Abbreviations

             DBOF       Defense Business Operations Fund
             DFAS       Defense Finance and Accounting Service
             DLH        direct labor hour
             DOD        Department of Defense
             GAO        General Accounting Office
             MTIS       materials turned into stores
             NOC        Naval Ordnance Center
             NWAD       Naval Warfare Assessment Division


             Page 11                                GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1

Introduction


                       When Defense established the Defense Business Operations Fund (DBOF)
                       in 1991, it was attempting to fundamentally alter the way DOD manages its
                       resources by fostering a more business-like culture within selected
                       defense operations. DBOF, a revolving fund financial structure, was
                       essentially an extension of the stock and industrial funds that have
                       operated within DOD for about 45 years. One of the primary goals of DBOF
                       was to identify the total costs of operations and to highlight the cost
                       implications of management decisions. The Navy ordnance business area
                       has operated under the industrial fund concept since 1953 and became
                       part of DBOF when it was established in 1991. On December 11, 1996, the
                       Navy ordnance business area became part of the Navy Working Capital
                       Fund when the Under Secretary of Defense (Comptroller) dissolved DBOF.
                       The Comptroller reorganized DBOF to clearly establish the military
                       services’ and DOD components’ responsibilities for managing the functional
                       and financial aspects of their respective business areas. The Navy Working
                       Capital Fund will continue to operate under the revolving fund concept
                       and charge customers the full costs of providing goods and services to
                       them as currently defined in DOD’s Financial Management Regulation,
                       Volume 11B, Reimbursable Operations, Policy and Procedures—Defense
                       Business Operations Fund.


                       During the 1940s, the Hoover Commission, while studying abuses in
Why Industrial Funds   government operations, found that the military budget and appropriation
Were Established       processes were highly inefficient. For example, the Commission found
                       that managers at industrial activities did not know the cost of individual
                       jobs and, therefore, concentrated on obtaining funds to support their
                       existing programs rather than improving the efficiency of their operations.
                       Similarly, the Commission found that, because industrial activities’
                       customers were not charged for the work performed, they were seldom
                       constrained by financial considerations.

                       To correct problems such as these, the Congress, in 1949, amended the
                       National Security Act of 1947 to authorize the establishment of industrial
                       funds.1 In establishing the funds, the Congress intended to introduce the
                       discipline and incentives of private industry and commerce to DOD
                       industrial activities and their customers. Industrial funds were expected to
                       improve government operations by establishing a buyer-seller relationship
                       between fund activities and their customers. The fund activities would be
                       financially dependent on obtaining orders and matching costs with
                       reimbursements. Consequently, they would be motivated to (1) improve

                       1
                        This authorization is now found at 10 U.S.C. 2208.



                       Page 12                                               GAO/AIMD/NSIAD-97-74 Navy Ordnance
                  Chapter 1
                  Introduction




                  cost estimates and controls and (2) identify and correct inefficiency and
                  waste. Customers would pay for services rendered and would, therefore,
                  be motivated to order only necessities.


                  In October 1991, DOD established DBOF, which consolidated the nine
DOD Established   existing industrial and stock funds operated by the military services and
DBOF              DOD, as well as the Defense Finance and Accounting Service, the Defense
                  Industrial Plant Equipment Service, the Defense Commissary Agency, the
                  Defense Reutilization and Marketing Service, and the Defense Technical
                  Information Service into a single financial structure. The military services
                  and DOD components continued to be responsible for managing and
                  operating the business activities within this financial structure. DBOF’s
                  fiscal year 1996 revenue of about $81 billion made it equivalent to one of
                  the largest corporations in the world.

                  Under the recently established four working capital funds, the business
                  areas will continue to operate the same way they did under DBOF. DBOF’s
                  primary goal and that of the current working capital fund structure 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
                  maintenance facilities, to provide quality goods and services at the lowest
                  cost. Accomplishing this will require DOD managers to become more
                  conscious of operating costs and make fundamental improvements in how
                  DOD conducts business. Unlike a private sector enterprise which has a
                  profit motive, the objective of DBOF and the four working capital funds is to
                  operate on a break-even basis by recovering the costs incurred in
                  conducting the business operations. It is critical for business areas to
                  operate efficiently since every dollar spent on infrastructure is one less
                  dollar available for other defense spending priorities. The business areas
                  provide essential goods and services needed for maintaining military
                  readiness including the (1) overhaul of ships, tanks, and aircraft and
                  (2) sale of over 5 million types of vital inventory items such as landing
                  gears for aircraft.

                  DBOF received its initial working capital of $6.5 billion through a transfer of
                  resources from the nine existing industrial and stock funds in 1991. As
                  figure 1.1 illustrates, the business areas used these resources to finance
                  the initial cost of providing the goods and services that are ordered by
                  their customers. Customers use appropriated funds, primarily Operation
                  and Maintenance appropriations, to finance these orders. Thereafter, as



                  Page 13                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                   Chapter 1
                                   Introduction




                                   the business areas perform work and incur costs, they bill customers on
                                   the basis of predetermined prices—commonly referred to as standard or
                                   stabilized prices. Payments from customers are then used to finance
                                   subsequent operations, much as sales revenues are used in commercial
                                   enterprises.


Figure 1.1: Working Capital Fund
Operations




                                                                                 Appropriates funds



                                                                 Customers
                                                         1. Place orders.
                                                         2. Obligate appropriations (when
                                                            accepted by the working capital
                                                            fund).
                                                         3. Receive requested goods and
                                                            services.
                                                         4. Reimburse the working capital
                                                            fund.

                                                                                                      Goods
                                       Customer                                                       and
                                       orders                                                         services
                                                               Billing    Payments




                                                            Working Capital
                                                            Fund
                                                         1. Receive customer orders,
                                                            screen, accept.
                                                         2. Perform work (incurring costs
                                                            for labor, material, and
                                                            contracts).
                                                         3. Provide goods and services.




                                   Page 14                                      GAO/AIMD/NSIAD-97-74 Navy Ordnance
                       Chapter 1
                       Introduction




                       Present DOD policy requires the business areas to establish prices that
Business Areas’        allow them to recover from their customers the expected costs, including
Budget and Price       any prior years’ losses. The business areas are to establish prices before
Setting Process        the start of each fiscal year and apply these predetermined prices to most
                       orders and requisitions received during the year. Because sales prices are
                       based on expected costs and workload, (1) higher-than-expected costs or
                       lower-than-expected customer demand for goods and services can cause
                       business areas to incur losses and (2) lower-than-expected costs or
                       higher-than-expected customer demand for goods and services can result
                       in profits. Therefore, in order for a business area to operate on a
                       break-even basis, it is extremely important that the business area
                       accurately estimate the work it will perform and the costs of performing
                       the work.

                       The process that business areas use to develop their stabilized prices
                       begins as early as 2 years before the prices go into effect, with each
                       business area developing workload projections for the budget year. After a
                       business area estimates its workload based on customer input, it (1) uses
                       productivity projections to estimate how many people it will need to
                       accomplish the work, (2) prepares a budget that identifies the labor,
                       material, and other expected costs, and (3) develops prices that, when
                       applied to the projected workload, should allow it to recover operating
                       costs from its customers.

                       Major commands responsible for the overall management of the various
                       business areas review and consolidate individual business area activities’
                       budget estimates. The military services’ and DOD components’
                       headquarters and the Office of the Secretary of Defense review the
                       consolidated estimates before they are submitted to the Congress as part
                       of the annual budget. Any changes made during the DOD budget review
                       process are incorporated into the business areas’ prices before the start of
                       the fiscal year.


                       In October 1993, the Navy reorganized the Navy ordnance business area
Navy Established the   and established the Naval Ordnance Center (NOC) in order to address
Naval Ordnance         various ordnance logistics management deficiencies that had been
Center                 identified during Desert Shield/Desert Storm operations and by various
                       working groups and studies. These deficiencies included (1) unresponsive
                       support to the fleets, (2) a fragmented inventory management function
                       that made it difficult for the fleets to identify the people who could resolve
                       their ordnance problems, and (3) an information system that did not give



                       Page 15                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1
Introduction




managers adequate visibility over ordnance. The creation of NOC was
expected to alleviate these problems and to allow the Navy to use a
streamlined and integrated ordnance team to “provide the right ordnance,
in the right quantity and condition, to the right customer, at the right place,
at the right time, and at the right cost.”

The establishment of NOC was also expected to save about $173 million
annually—primarily by consolidating ordnance support functions
previously performed by the Naval Air Systems Command, Naval Sea
Systems Command, Naval Supply Systems Command, and five fairly
autonomous Naval weapons stations. The $173 million in savings would be
shared by these components. Specifically, the Navy expected to save most
of the money by transferring ordnance-related headquarters functions
from the three systems commands to NOC Headquarters, transferring most
of the weapons stations’ administrative functions to two new divisions
(Atlantic and Pacific Divisions), and consolidating in-service engineering
support for ordnance items. Currently, the Navy ordnance business area
consists of NOC Headquarters and the Atlantic and Pacific Divisions
described above; five Naval weapons stations; two weapons station
detachments; the Naval Warfare Assessment Division; and the Inventory
Management and Systems Division. NOC’s activities and their locations are
shown in figure 1.2.




Page 16                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                           Chapter 1
                                           Introduction




Figure 1.2: Naval Ordnance Center Activities




                Port Hadlock




                                                                                           Earle
                                                                                   2
            Concord

                                                                                          Yorktown and Atlantic Division

                 Seal Beach and Pacific Division
                   Fallbrook
                                                                                  Charleston
 1




                                                                                                Headquarters

                                                                                                Activities

                                                                                           1. Navy Warfare Assessment
                                                                                              Division
                                                                                           2. Inventory Management
                                                                                              System Division




                                           Although this business area was called the Navy ordnance depot
                                           maintenance business area until December 1996, only 4 percent of the
                                           work preformed by the business area involves depot maintenance. DOD
                                           defines depot maintenance as material maintenance requiring major
                                           overhaul or a complete rebuilding of parts, assemblies, subassemblies, and
                                           end items. However, as shown in figure 1.3, one of the business area’s core
                                           requirements and largest workloads—ammunition storage and




                                           Page 17                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                        Chapter 1
                                        Introduction




                                        distribution—involves the receipt, segregation, storage and issue of
                                        ammunition, as well as all services related to ammunition loading and
                                        unloading of naval ships and commercial vessels.2 Other workloads
                                        include (1) ordnance engineering services, such as gauging the war
                                        fighting capacity of ships and aircraft—from unit to battle group level—by
                                        assessing the suitability of design and performance of weapons,3
                                        (2) general support, such as providing security, real property maintenance,
                                        and other base operations support services to the weapons stations’ tenant
                                        activities, and (3) performing intermediate level maintenance, such as
                                        replacing defective ordnance components. Recognizing that this business
                                        area did not perform much depot maintenance work, DOD changed the
                                        name of the business area to Navy ordnance in December 1996.



Figure 1.3: Navy Ordnance Workload as a Percent of Revenue



                                            23.0%      Ammunition storage and distribution



                                                                      9.0% Intermediate maintenance

                                                                          4.0% Depot maintenance




                                                                          7.0%     Exempt from stabilized rate
 Engineering    40.0%


                                                             17.0% General support




                                        Over the last several years, the amount of work that this business area has
                                        received from its customers has steadily declined due to the downsizing
                                        and realignment actions that have been occurring throughout the DOD
                                        military force structure. As shown in figure 1.4, the amount of work

                                        2
                                          See Defense Ammunition: Significant Problems Left Unattended Will Get Worse (GAO/NSIAD-96-129,
                                        June 21, 1996), for problems related to the storage of ammunition.
                                        3
                                        This mission is accomplished by the Naval Warfare Assessment Division, which is located in Corona,
                                        California.


                                        Page 18                                                  GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                            Chapter 1
                                            Introduction




                                            performed by NOC declined from a reported 9.7 million DLHs in fiscal year
                                            19924 to 5.1 million DLHs in fiscal year 1996—a 47 percent decrease. At the
                                            same time, NOC has reduced its personnel from 8,904 to 5,363—a
                                            40 percent reduction. While the number of personnel has decreased, it has
                                            not been proportional to the decrease in workload because of the
                                            difficulty involved in quickly releasing employees when the workload
                                            declines.



Figure 1.4: Navy Ordnance Workload (in Millions of Direct Labor Hours)


12


10


 8


 6


 4


 2


 0
     1992                    1993                        1994                           1995                          1996
                                                      Fiscal Year


                                            Source: Navy Ordnance Business Area.



                                            The objectives of our audit were to determine (1) the causes of the Navy
Objectives, Scope,                          ordnance business area price increases that took place from fiscal year
and Methodology                             1994 through fiscal year 1996, (2) why the Navy ordnance business area

                                            4
                                             The amount of work performed in fiscal year 1992 was extraordinarily high due to Desert
                                            Shield/Desert Storm.



                                            Page 19                                                  GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1
Introduction




incurred about $212 million in reported losses during that 3-year period,
and (3) whether management has accurate and consistent financial
management information for effectively managing the Navy ordnance
business area.

To determine what factors caused the prices to increase between fiscal
years 1994 and 1996, we obtained and analyzed NOC’s workload budgets for
fiscal years 1994 through 1996 and compared them with actual workload
results to identify variances from budgeted amounts. For identified
differences, we met with responsible accounting and program officials to
ascertain (1) why there were differences and (2) how the differences
affected prices. We also analyzed the budgets for fiscal years 1994 through
1996 to determine the cost factors used in developing the prices. We met
with responsible Navy comptroller and program officials at NOC
Headquarters, the Atlantic and Pacific Divisions, and selected weapon
stations to identify and discuss the rationale for the various factors used
(or not used) to develop the Naval ordnance business area’s prices it
charged customers.

To determine what factors caused the Navy ordnance business area to
incur about $212 million in reported losses from fiscal year 1994 through
fiscal year 1996, we analyzed budget reports and related data for fiscal
years 1994 through 1996 and compared budgeted direct and overhead
costs to actual direct and overhead costs to identify variances from the
budgeted amounts. For identified differences, we met with responsible
accounting and program officials to ascertain (1) why there were
differences and (2) how the differences resulted in losses incurred by the
Navy ordnance business area.

To determine if management had accurate and consistent information for
effectively managing the business area, we reviewed (1) workload
forecasts to determine if they were accurate, (2) the NOC’s uniform price
concept and the impact that this practice has on the individual weapons
station net operating results, and (3) the allocation of overhead costs to
specific workloads to determine if they were accurate. We also reviewed
DOD Inspector General and Naval Audit Service Chief Financial Officer
reports on the business area’s financial statements to identify any
problems they may have found with the business area’s financial
information. We did not independently verify the financial information
provided by the Navy ordnance business area.




Page 20                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1
Introduction




We performed our work at the Office of the DOD Comptroller, Washington,
D.C.; the Offices of the Assistant Secretary of Navy (Financial
Management and Comptroller), Naval Sea Systems Command, Naval Air
Systems Command, and Headquarters, Defense Finance and Accounting
Service, all located in Arlington, Virginia; the Naval Ordnance Center
Headquarters, Indian Head, Maryland; the Naval Ordnance Center Atlantic
Division, Yorktown, Virginia; the Naval Ordnance Center Pacific Division,
Seal Beach, California; the Naval Weapons Station, Yorktown, Virginia; the
Naval Weapons Station, Charleston, South Carolina; the Naval Weapons
Station, Earle, New Jersey; the Naval Weapons Station, Seal Beach,
California; the Naval Weapons Station, Concord, California; and the Naval
Warfare Assessment Division, Corona, California. Our work was
performed from June 1996 through February 1997 in accordance with
generally accepted government auditing standards.

DOD provided written comments on a draft of this report. We incorporated
DOD’scomments where appropriate. These comments are discussed in
chapters 3 and 4 and are reprinted in appendix I.




Page 21                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 2

Factors Causing Prices to Increase


                                       The Navy ordnance business area’s composite sales price increased from
                                       $50.02 per DLH in fiscal year 1994 to $89.03 per DLH in fiscal year 1996, or
                                       about 78 percent.1 As this chapter discusses, a large part of this
                                       increase—39.1 percent—was due to efforts to ensure that the business
                                       area’s prices fully reflect the cost of providing goods and services to
                                       customers—a primary goal of working capital funds. About 50 percent of
                                       the price increase, however, was attributable to two other factors: (1) the
                                       Navy’s compliance with a Defense requirement to reflect prior-year profits
                                       and losses in prices and (2) the spreading of overhead costs to fewer DLHs
                                       due to a rapidly declining workload. Each of the causes for the price
                                       increase are shown in table 2.1. Setting prices based on full costs allows
                                       business area managers to make more informed policy decisions;
                                       however, they have also caused some ordnance customers to find other
                                       sources to perform their work at lower prices.

Table 2.1: Major Causes of the Navy
Ordnance Business Area’s Fiscal Year                                                                        Impact on                  Percent of
1994-96 Sales Price Increase           Cause of increase                                                         rate                   increase
                                       Additional cost components captured                                       $15.25                        39.1
                                        that were previously financed by other
                                        appropriations or major commands
                                       Prior year losses                                                          13.79                        35.3
                                       Declining workload                                                           5.46                       14.0
                                       Direct labor costs                                                           4.51                       11.6
                                       Total                                                                     $39.01                      100.0



                                       The Navy ordnance business area has been working to implement DBOF
Current Prices More                    and is capturing more of the total cost of its operations and reflecting
Accurately Reflect                     those costs in the prices charged customers. As shown in table 2.1, our
Total Cost of                          analysis indicates that $15.25, or about 39.1 percent, of the Navy ordnance
                                       business area’s price increase from fiscal year 1994 to fiscal year 1996 was
Operations                             attributable to Navy and DOD efforts to ensure that all relevant costs were
                                       identified and included in the sales prices. Until the establishment of DBOF
                                       in October 1991, significant overhead costs were (1) contained in different
                                       organization structures and paid by different appropriations or major
                                       commands and (2) excluded from the prices charged customers. DBOF’s
                                       total cost concept, along with the Navy’s reorganization, consolidated
                                       Navy ordnance costs by shifting the costs from the different organization
                                       structures to the Navy ordnance business area. These previously excluded
                                       costs relate to (1) overhead and (2) underutilized plant capacity.

                                       1
                                        If the fiscal year 1994 sales price is converted to fiscal year 1996 dollars, it would be $52.47 per direct
                                       labor hour. This would reduce the increase in price to 70 percent.



                                       Page 22                                                      GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                  Chapter 2
                                  Factors Causing Prices to Increase




Fiscal Year 1996 Prices           About $7.93 of the $15.25 price increase can be attributed to overhead
Include New Costs                 costs that were included in the 1996 prices, but not the 1994 prices. These
                                  costs include

                              •   $12.5 million for military security guards, which were previously financed
                                  by the Military Personnel, Navy appropriation ($2.19 per DLH);
                              •   $11.9 million for Navy ordnance headquarters functions, which were
                                  previously financed by the Operation and Maintenance, Navy
                                  appropriation ($2.09 per DLH);
                              •   $10.8 million for the Inventory Management Support Division, which was
                                  previously financed by DBOF’s Navy supply management business area
                                  ($1.89 per DLH); and
                              •   $10 million for functions related to explosive safety, nuclear security,
                                  ordnance handling, and sensitive ordnance security, which were
                                  previously financed by the Operation and Maintenance, Navy
                                  appropriation ($1.76 per DLH).

                                  By including these additional costs in the prices, business area managers
                                  can more easily focus on and manage the relevant costs. In addition, the
                                  more accurate identification of costs should enable those responsible for
                                  providing oversight to make more informed policy decisions.


Cost of Underutilized Plant       Like many of the business areas, the Navy ordnance business area must
Capacity Now Included in          always maintain the capability to meet rapid escalation of demand for its
Sales Prices                      services in times of war or other military emergencies. A 1994 DOD policy
                                  change affected the way costs associated with maintaining this
                                  mobilization capability are financed and is responsible for $7.32 of the
                                  $15.25 price increase. According to the DOD Financial Management
                                  Regulation, Volume 11B, mobilization capability costs include costs to
                                  maintain a surge capability, to procure and maintain approved war reserve
                                  material levels, and/or maintain other assets, functions, or capabilities
                                  required to meet an operational contingency.

                                  Under the old policy, if underutilized facilities, equipment, or
                                  infrastructure were needed in order to meet mobilization surge
                                  requirements, then the costs related to maintaining the underutilized
                                  assets were to be determined, budgeted, and financed by a direct
                                  appropriation—rather than as overhead costs that are incorporated into
                                  customers’ sales prices. While the Navy ordnance business area used the
                                  facilities and equipment, that use was less than the full capacity of an
                                  operating facility.



                                  Page 23                                    GAO/AIMD/NSIAD-97-74 Navy Ordnance
                        Chapter 2
                        Factors Causing Prices to Increase




                        However, under the new policy, the cost of maintaining these assets is not
                        funded as a mobilization requirement unless the assets are expected to be
                        unused for 6 consecutive months. This policy change also addressed
                        concerns that the Senate Appropriations Committee raised in its reports
                        on DOD’s fiscal years 1994 and 1995 appropriations.2 Specifically, the
                        committee reports questioned the need for funding underutilized plant
                        capacity and noted that using direct appropriations to subsidize Navy
                        industrial maintenance facilities was contrary to the DBOF concept of
                        capturing the full cost of operations.


                        As noted previously, DOD policy requires business areas to adjust their
Prior Year Losses       prices in order to recoup accumulated losses from or return accumulated
Increase Sales Prices   profits to their customers. In accordance with this policy, the business
                        area decreased its fiscal year 1994 sales prices to return a profit of
                        $38.1 million that was projected for the end of fiscal year 1993. Similarly,
                        when it established the business area’s fiscal year 1996 prices, the Navy
                        increased its prices to recoup a loss of about $47 million that was
                        projected for the end of fiscal year 1995. Following this policy resulted in a
                        net increase of $13.79 per hour, or about 35 percent, of the price increase
                        from fiscal year 1994 to fiscal year 1996.

                        To illustrate the potential magnitude and impact of including prior year
                        losses in prices, Navy ordnance comptroller officials pointed out that their
                        business area’s accumulated loss at the end of fiscal year 1997 is expected
                        to be about $220 million. To recoup this loss, the Navy could either (1) add
                        about $49 to the fiscal year 1998 prices—a 60 percent increase over the
                        fiscal year 1997 prices—an increase high enough to drive more customers
                        away or (2) seek a $220 million direct appropriation. DOD and the Navy
                        decided to increase the prices charged customers for ammunition storage
                        and distribution to recover these losses.


                        Since the military forces have been downsizing over the last several years,
Declining Workload      the demand for Navy ordnance work has declined. However, the business
Creates Pressure to     area’s overhead costs have not decreased proportionately to the decline in
Increase Prices         workload. This has caused the business area to allocate its overhead costs
                        over a steadily declining workload base and, in turn, to allocate more
                        overhead costs to each DLH of work that is accomplished. Our analysis
                        indicates that workload reductions accounted for $5.46, or about
                        14 percent, of the price increase from fiscal year 1994 through fiscal year

                        2
                         Senate Reports 103-153 and 103-321.



                        Page 24                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                         Chapter 2
                                         Factors Causing Prices to Increase




                                         1996. The magnitude of these workload reductions affects the amount of
                                         budgeted overhead cost per DLH as illustrated in table 2.2.

Table 2.2: Budgeted Overhead Costs
and Direct Labor Hours for Fiscal                                             Budgeted           Budgeted direct                Budgeted
Years 1994 and 1996                                                      overhead costs             labor hours             overhead cost
                                         Fiscal year                          (millions)              (millions)                 per DLHa
                                         1994                                         $206                       6.9                  $29.72
                                         1996                                         $200b                      5.7                  $35.18
                                         a
                                         Price per hour may not be precise due to rounding.
                                         b
                                           The total budgeted overhead cost was $287 million for fiscal year 1996. In order to compare the
                                         fiscal year 1994 and 1996 budgeted overhead figures, we adjusted the fiscal year 1996 figure by
                                         $87 million because (1) new overhead costs were added and (2) of a change in the financing of
                                         underutilized plant capacity.




                                         Due to higher prices, some customers are shifting work from the Navy
Higher Prices Result                     ordnance business area to other sources. Customers are shifting work
in Customers Shifting                    from the business area to nonworking capital fund activities that are not
Work From Navy                           required to charge the full cost of doing business, such as not charging the
                                         cost of military personnel. Since the Navy ordnance business area is
Ordnance Business                        required to charge customers the full cost and nonworking capital fund
Area                                     activities are not required to do so, this situation creates a competitive
                                         disadvantage for the Navy ordnance business area. Further, some
                                         customers shifted work to other working capital fund activities that are
                                         capturing full costs but offering lower prices. Some examples follow.

                                     •   In one instance related to the calibration maintenance of the Mark 48
                                         torpedo support equipment, we found that the work previously done by
                                         the Yorktown Weapons Station was now being done at an activity located
                                         at the Norfolk Naval base for about one third of the price. According to the
                                         commander of the Mark 48 torpedo maintenance facility, which was also
                                         located on the Yorktown Weapons Station, he paid the Norfolk Naval base
                                         about $40,000 during fiscal year 1996 for over 1,000 hours of work. The
                                         commander told us that if he had given the work to Yorktown, he would
                                         have been charged about $110,000 or about three times as much. The large
                                         difference in prices occurred because the Norfolk activity was not a
                                         working capital fund business activity and thus was not required to charge
                                         labor and overhead costs which Yorktown, being a working capital fund
                                         activity, had to charge. The Norfolk activity only charged the costs of
                                         pieces and parts needed to perform the calibration work on the torpedo
                                         support equipment.




                                         Page 25                                                 GAO/AIMD/NSIAD-97-74 Navy Ordnance
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    Factors Causing Prices to Increase




•   In another case, the Concord Naval Weapons Station lost about 103,000
    DLHs of work related to the Air Force’s prepositioned ships program that
    had been included in its fiscal year 1997 budget. Concord has performed
    this work, which involves loading and unloading ammunition ships, for the
    last several years. However, the Army’s military ocean terminal at Sunny
    Point, North Carolina—which performed much of the work prior to
    1993—won a formal competition for the work in fiscal year 1997.
    According to Air Force program managers, Concord was as qualified to do
    the work as Sunny Point. However, these managers said that a major
    factor in deciding to award the work to Sunny Point was that its
    $9.5 million bid was about $3 million less than Concord’s bid. In discussing
    this matter with Concord officials, they indicated that the elimination of
    this workload will result in a loss of about $7 million—primarily because it
    will (1) prevent them from recouping about $6.5 million in fixed overhead
    costs and prior year losses, and (2) force them to place some of their
    workers into overhead positions for part of the year.
•   We also found that the Naval Ships Parts Control Center, which was
    previously a Yorktown customer, transferred its workload related to the
    inspection and repair of various steam valves and other items of materials
    turned into stores (MTIS) by Navy submarines. According to the Acting
    Director of Ship Parts Control Center’s MTIS program, the work was
    transferred to the Defense Distribution Depot Norfolk, also a working
    capital fund activity, primarily because Norfolk charged substantially less
    than Yorktown. For example, at the time of transfer on October 1, 1995,
    Yorktown was charging $180 to inspect and repair each lot of MTIS. This
    was about 200 percent more than the $61 per lot charged by the Norfolk
    Depot. The Director also told us that primary factors contributing to
    Yorktown’s higher costs were the large amounts of overhead included in
    the prices and Yorktown’s use of inspectors to perform the work as
    opposed to lower paid depot warehousemen at the Norfolk Depot.

    The operating environment of declining workloads and increasing prices is
    common among many business areas and is one of the most critical
    challenges DOD currently faces. In an April 1994 testimony, the Under
    Secretary of Defense (Comptroller) referred to this environment as a
    “vicious circle” and indicated that DOD’s inability to eliminate
    infrastructure costs as fast as customer budgets are being reduced is at the
    center of the dilemma. Specifically, he indicated that (1) higher prices are
    causing business area customers to reduce their demand for goods and
    services, (2) business areas are generally unable to reduce their costs
    quickly enough to respond to the reduced demand, (3) as a result, the
    business areas are incurring losses that, under current DOD policy, must be



    Page 26                                    GAO/AIMD/NSIAD-97-74 Navy Ordnance
              Chapter 2
              Factors Causing Prices to Increase




              recouped through price increases, and (4) the price increases start the
              whole “vicious circle” over again. As shown above, the Comptroller’s
              statement is as valid today as it was 3 years ago and the Navy ordnance
              business area will continue to experience this “vicious circle” until it
              reduces its infrastructure costs.


              The Navy’s implementation of DBOF along with the reorganization to
Conclusions   consolidate ordnance functions has helped ensure that the Navy ordnance
              business area’s prices reflect the total cost of doing business—a primary
              objective of DBOF and the recently established working capital funds.
              Setting prices based on the full costs of providing goods and services has
              increased prices which, in turn, has helped to (1) identify key areas
              contributing to inefficient operations within the business area,
              (2) highlight the cost implications of management decisions, and
              (3) provide managers with information for use in improving their
              operations. On the other hand, the increases have also caused customers
              to seek alternatives to the Navy ordnance business area. Improving the
              efficiency of Navy ordnance operations will help alleviate his problem.
              This concept is discussed more fully in the next chapter.




              Page 27                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 3

Factors Contributing to Navy Ordnance
Business Area Losses

                                        The Navy ordnance business area reported it lost about $212 million
                                        during fiscal years 1994 through 1996, and would have lost more if it had
                                        not been allowed to add surcharges to its fiscal year 1995 and 1996 prices
                                        in order to recoup prior year losses. Although many factors contributed to
                                        these losses, our analysis indicates that they occurred primarily because
                                        the business area (1) had higher-than-expected overhead costs, (2) did not
                                        receive as much work as expected, and (3) had to pay for work that
                                        reserve component units were expected to perform, but did not. In
                                        determining the reasons for the losses, we compared budgeted
                                        information to actual information for fiscal years 1994 through 1996. Some
                                        of the reasons for the losses, such as unanticipated overhead costs related
                                        to headquarters activities, also contributed to the price increases that were
                                        discussed in chapter 2.


                                        The annual DBOF budgets that have been submitted to the Congress have
Projected Operating                     consistently contained overly optimistic estimates for the Navy ordnance
Results Have                            business area’s operating results. For example, due to the DOD policy that
Consistently Been                       requires activities to use surcharges to recoup prior year losses from their
                                        customers, the business area was expected to earn a profit of about
Overly Optimistic                       $47.7 million during fiscal year 1996; however, instead of making a profit,
                                        the business area reported it actually lost about $36.7 million during the
                                        year. Thus, these surcharges allowed the business area to reduce its losses
                                        and caused its performance to appear better than it actually was.

                                        Altogether, the Navy ordnance business area was expected to earn a profit
                                        of $98.6 million during fiscal years 1994 through 1996. However, as shown
                                        in table 3.1 and figure 3.1, because the business area’s performance was
                                        consistently worse than expected, it incurred a net reported loss of
                                        $211.8 million during the period.

Table 3.1: Navy Ordnance Business
Area’s Budgeted (Estimated) and         Dollars in millions
Actual Reported Operating Results for              1994                      1995                 1996                 Total
Fiscal Years 1994-96
                                        Budget                Actual Budget         Actual Budget        Actual Budget         Actual
                                        ($38.1)               ($165.5)   $89.0       ($9.6)   $47.7      ($36.7)   $98.6   ($211.8)




                                        Page 28                                               GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                           Chapter 3
                                           Factors Contributing to Navy Ordnance
                                           Business Area Losses




Figure 3.1: Estimated (Budgeted) vs. Actual Results

150
                                                                                                  Estimated
                                                                                                  Actual
100


 50

  0


 -50


-100


-150


-200


-250
          FY 1994            FY 1995            FY 1996                   Total




                                           Source: Navy Ordnance Business Area.



                                           The primary cause of the business area’s losses is that overhead costs have
Overhead Costs Have                        been much higher than expected. Specifically, as shown in table 3.2 and
Been Much                                  figure 3.2, actual reported overhead costs for fiscal years 1994 through
Higher-Than-Expected                       1996 were about $197.5 million,1 or about 29 percent, higher than budget
                                           estimates. Because the (1) budgets are prepared 18 to 20 months before
                                           the beginning of the fiscal year and (2) Navy ordnance business area
                                           reorganized in October 1993, the business area could not accurately
                                           estimate overhead costs for fiscal years 1994 and 1995, as we discussed in
                                           chapter 2. For fiscal year 1996, the business area was better able to



                                           1
                                            About $63 million of this difference is due to the fact that the Navy ordnance business area did not
                                           receive the underutilized plant capacity funding it had budgeted for in fiscal year 1994.



                                           Page 29                                                    GAO/AIMD/NSIAD-97-74 Navy Ordnance
                                          Chapter 3
                                          Factors Contributing to Navy Ordnance
                                          Business Area Losses




                                          estimate overhead costs since it had been in operation under its new
                                          organizational structure for about 1 year.

Table 3.2: Navy Ordnance Business
Area’s Budgeted and Actual Reported       Dollars in millions
Overhead Costs for Fiscal Years                        1994                      1995            1996               Total
1994-96
                                          Budget                Actual     Budget Actual      Budget Actual     Budget Actual
                                          $205.5                $325.5      $191.2 $272.2      $287.4 $283.9     $684.1 $881.6




Figure 3.2: Estimated (Budgeted) vs. Actual Overhead


1,000
                                                                                            Estimated
                                                                                            Actual

  800



  600



  400



  200



     0
            FY 1994           FY 1995            FY 1996                 Total



                                          Source: Navy Ordnance Business Area.




                                          Page 30                                            GAO/AIMD/NSIAD-97-74 Navy Ordnance
                         Chapter 3
                         Factors Contributing to Navy Ordnance
                         Business Area Losses




                         According to Navy ordnance officials and our analysis, these
                         higher-than-expected overhead costs were primarily due to three factors:
                         (1) it incurred new and unanticipated costs that were previously financed
                         with other appropriations or by the Navy’s major commands, (2) the
                         weapons stations did not achieve productivity and cost reduction goals
                         that were incorporated into their budgets by Navy and DOD budget
                         officials, and (3) it is difficult for managers to reduce the size of their
                         workforce quickly enough to respond to declining workloads, especially
                         when unanticipated workload shortfalls occur. When the business area is
                         confronted with higher-than-expected overhead costs, it is precluded by
                         DOD’s price stabilization policy from passing on unanticipated cost
                         increases—including overhead costs—to customers during the fiscal year.


Business Area Absorbed   DOD  policy requires business areas to establish sales prices that allow them
Unanticipated Costs      to recover their expected costs from their customers. It also requires them
                         to establish their prices before the start of each fiscal year and to apply
                         these predetermined or “stabilized” prices to all orders received during the
                         year—regardless of when the work is actually accomplished or what costs
                         are actually incurred. Because sales prices are based on expected rather
                         than actual costs, higher-than-expected costs can cause a business area to
                         incur losses and lower-than-expected costs can result in profits.

                         DOD established this “price stabilization” policy in 1975 to protect revolving
                         fund customers from unforeseen inflationary increases and other cost
                         uncertainties. The intent of the policy is to ensure that customers will not
                         have to reduce their programs because of higher-than-expected prices.
                         This policy should also allow customers to provide more reliable workload
                         estimates to business areas which, in turn, should allow the activities to
                         better plan for the efficient use of their resources. We agree with this
                         policy since the policy protects appropriated fund customers from
                         unforeseen changes. This enables the customers to buy goods and services
                         from the four working capital funds as shown in the budgets presented to
                         the Congress. For example, if a customer needed 100 engines overhauled,
                         a change in the price may result in the customer only having enough funds
                         to have 75 engines overhauled, thereby impacting the customers’ readiness
                         capability.

                         When a business area is confronted with higher-than-expected costs, it is
                         precluded by DOD’s price stabilization policy from increasing prices
                         charged customers during the fiscal year. For example, the business area’s
                         fiscal year 1994 sales prices were based on the assumption that the cost of



                         Page 31                                     GAO/AIMD/NSIAD-97-74 Navy Ordnance
                     Chapter 3
                     Factors Contributing to Navy Ordnance
                     Business Area Losses




                     maintaining underutilized plant capacity (to meet wartime contingency
                     requirements) would be financed through a transfer of $63.2 million from
                     the Navy Operation and Maintenance appropriation; however, as
                     discussed previously, this method of financing underutilized capacity was
                     changed after the stabilized prices had been established and, as a result,
                     the business area incurred the costs but could not pass them on to its
                     customers.

                     Similarly, many costs related to the establishment of NOC were not
                     included in the business area’s fiscal year 1994 prices and, as a result, the
                     business area incurred the costs but could not pass them on to its
                     customers in that year. For example, Navy ordnance officials estimate that
                     the business area lost about $16.9 million since the fiscal year 1994 prices
                     were developed before the reorganization of the business area and thus
                     did not include the cost of headquarters functions that were transferred
                     from the Navy’s three systems commands and inventory management
                     functions that were transferred from the Navy’s supply management
                     business area.


Anticipated Budget   Another major contributor to the business area’s higher-than-expected
Savings Did Not      overhead costs was the failure to achieve cost reductions and productivity
Materialize          improvement goals that were incorporated into budget estimates. For
                     example, Navy ordnance officials estimate that the business area lost
                     about $13 million in fiscal year 1994 as a result of Defense Management
                     Report Decisions that reduced their cost estimates based on the invalid
                     assumption that (1) the establishment of DBOF would result in a 1-percent
                     reduction in costs and (2) additional savings could be achieved by
                     consolidating automated data processing functions. Because these cost
                     reductions did not materialize, the business area incurred the costs which
                     were not fully recouped by the prices it was charging.

                     In another case, a DOD budget analyst questioned the Navy’s decision to
                     reduce cost estimates based on the assumption that general and
                     administrative costs could be reduced by 3 percent a year during the fiscal
                     year 1996 budget review process. Specifically, the analyst noted that (1) no
                     additional guidance or policy direction, plan, program, or detailed action
                     was provided to show how the savings would be achieved, (2) NOC and the
                     weapons stations had not achieved prior productivity goals that had also
                     focused on overhead costs, and (3) the new savings goal that was not
                     supported by any identifiable plan appeared to be a repeat of the same
                     error. The budget analyst also pointed out that overly optimistic savings



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                         assumptions such as these had contributed to the losses that the business
                         area had incurred over the last several years.


Properly Matching        A final major cause of the Navy ordnance business area’s
Workload and Workforce   higher-than-expected overhead costs is that it has not been able to quickly
Size Is Difficult        and effectively reduce its workforce to meet the declining demand for
                         goods and services. For example, Navy ordnance officials stated that they
                         incurred losses during fiscal year 1995 because they had to retain
                         unneeded personnel until the workforce could be reduced through either
                         early retirement and separation incentive pay or a reduction-in-force.
                         These officials pointed out that the problem of not being able to quickly
                         reduce workforce levels to meet demand has been exacerbated by their
                         limited ability to control which personnel and skills are retained.

                         Navy ordnance officials can limit the adverse impact of this problem if
                         they have sufficient time to plan for changes or can use temporary
                         workers. For example, if they could forecast major workload reductions 2
                         years in advance, they could restrict hiring during the intervening 2 years
                         and, if appropriate, initiate other actions such as offering separation
                         incentive pay or implementing a reduction-in-force. Another possible
                         solution is to use temporary and intermittent2 workers for all but a core or
                         base-level workload. For example, as of September 30, 1996, 225, or about
                         37 percent, of the Concord Navy Weapons Station’s employees were either
                         temporary or intermittent workers. However, the use of temporary and
                         intermittent workers is much less common at the rest of the business
                         area’s activities and, as of September 30, 1996, only 278, or about
                         7 percent, of the business area’s remaining employees were either
                         temporary or intermittent workers.


                         The Navy ordnance business area lost about $39.8 million during fiscal
Lower-Than-              years 1994 through 1996 because lower-than-expected workload levels
Expected Workload        prevented it from generating enough revenue to recover its overhead
Levels Also              costs. According to Navy ordnance officials, overhead costs for such
                         things as the salaries of administrative personnel are generally fixed costs
Contributed to the       over the short term and are, therefore, usually incurred regardless of the
Losses                   amount of work received during the year. As a result, as shown in table
                         3.3, a shortfall of 304,617 DLHs of work in fiscal year 1994 resulted in a loss



                         2
                          Temporary workers are hired for a specified period of time, while intermittent workers are permanent
                         employees who are used only when needed.



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                                       of about $9.1 million, and a shortfall of 609,793 hours in fiscal year 1996
                                       resulted in a loss of about $30.8 million.

Table 3.3: Losses Caused by Workload
Shortfalls                                                                                                 Budget
                                       Fiscal                    Workload (DLHs)                        overhead           Loss
                                       year               Budget               Actual   Shortfall   costs per DLH     (millions)
                                       1994             6,915,205        6,610,588      304,617            $29.72         $ 9.1
                                       1996             5,697,500        5,087,707      609,793            $50.44          30.8
                                       Total          12,612,705        11,698,295      914,410                           $39.8a
                                       a
                                       Total is not precise due to rounding.



                                       During the fiscal year 1996 budget review process, which occurred in late
                                       1994, both Navy and DOD budget analysts expressed concern about
                                       apparent differences between the Navy ordnance business area’s
                                       workload estimates and those of its customers. Our analysis showed that
                                       these problems continued when the business area’s fiscal year 1997 budget
                                       was developed. For example, Navy ordnance officials used a workload
                                       estimate of 6.3 million DLHs to develop their fiscal year 1997 sales prices,
                                       however, after the prices were set, the officials reduced the estimate by
                                       about 1.6 million hours, or about 25 percent. As a result, they now expect
                                       to incur about $66 million in losses in fiscal year 1997. Chapter 4 discusses
                                       this problem in more detail.


                                       The Navy ordnance business area lost about $13 million during fiscal years
Naval Reserve Units                    1994 through 1996 because it had to pay for work that Naval Reserve units
Have Not Provided                      were expected to accomplish but did not. This work was to be
Expected Level of                      accomplished as part of a cost savings initiative that was expected to
                                       eventually save about $18 million a year. The basic concept was for
Support                                reservists to accomplish work at weapons stations during their weekend
                                       drills and annual training periods and to thereby eliminate the need for
                                       about 450 civilians workers. In return for this support, the business area
                                       was required to reimburse the Reserve Personnel, Navy appropriation.

                                       The losses occurred because the business area was required by Navy
                                       policy to reimburse the Reserve Personnel, Navy appropriation based on
                                       expected levels of support that subsequently did not materialize and were
                                       determined to be unattainable. For example, Navy ordnance officials
                                       estimate that they lost about $6 million during fiscal year 1994 because
                                       they paid the Reserve Personnel, Navy appropriation $8 million for the




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                  equivalent of 222 years of support but actually received only 58 years of
                  support.

                  A December 1996 Naval Audit Service report3 concluded that “The
                  reservists capability to provide contributory support was so limited that
                  no significant savings were achievable and reimbursement for
                  contributory support was not supportable. Our review showed that about
                  50 percent of the reservists lacked military rating skills for ordnance
                  handling and 51 percent of the reservists had less than 1-year of
                  experience in their reserve billets.” The Chief of Naval Operations has
                  subsequently agreed to implement a Naval Audit Service recommendation
                  to discontinue the reimbursement requirement, effective October 1, 1997.


                  The Navy ordnance business area has not been able to meet its financial
Conclusions       goal of operating on a break-even basis. For fiscal years 1994 through
                  1996, the business area reported losses of about $212 million primarily
                  because (1) actual overhead costs exceeded budgeted overhead costs and
                  (2) it did not receive as much work as expected. These problems continue
                  to exist and Navy ordnance comptroller officials believe that the business
                  area will incur losses of about $66 million in fiscal year 1997. The Navy
                  ordnance business area will likely continue to increase its prices and/or
                  lose millions of dollars—as it has in the past—until it effectively plans for
                  and reduces its infrastructure costs, especially overhead costs, so that
                  these costs are commensurate with reduced customer demand for
                  ordnance services.


                  To ensure that the Navy ordnance business area operates on a break-even
Recommendations   basis, we recommend that the Secretary of Defense direct the Secretary of
                  the Navy to develop a plan to streamline the Navy ordnance operations
                  and reduce its infrastructure costs, especially overhead costs. This plan
                  should (1) concentrate on eliminating unnecessary infrastructure,
                  including overhead, (2) identify specific actions that need to be
                  accomplished, (3) include realistic assumptions about the savings that can
                  be achieved, (4) establish milestones, and (5) clearly delineate
                  responsibilities for performing the tasks in the plan.




                  3
                   “Use of and Reimbursement for Reserve Military Manpower at Naval Weapons Stations” (007-97).



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                     DOD agrees with our recommendation to develop a plan to streamline Navy
Agency Comments      ordnance operations and reduce its infrastructure costs, especially
and Our Evaluation   overhead costs.




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Chapter 4

Effective Management and Oversight
Requires Accurate and Consistent Financial
Information
                     Having reliable and readily accessible financial management information
                     is essential to the effective and efficient operation of any business entity
                     since it enables managers to account for past activities, manage current
                     operations, and assess progress toward planned objectives. For a
                     revolving fund operation, such as the Navy ordnance business area, this
                     would mean that managers need to have accurate and consistent
                     information on work to be performed and the price charged customers
                     that should reflect the cost of performing the work. Such information
                     would help managers ensure that (1) revenue is based on the amount of
                     work performed and the price charged for that work and (2) revenue
                     approximates the cost of performing the work, in accordance with the
                     goal of operating business areas on a break-even basis. This information
                     could also be used to identify operational inefficiencies so that managers
                     can take appropriate actions.

                     As noted earlier in this report, for fiscal years 1994 through 1996, the Navy
                     ordnance business area has reported losses of about $212 million and
                     estimates that it will lose about $66 million in fiscal year 1997. We found
                     that management’s ability to stem these losses is being hindered by the
                     absence of the essential information we cited above. Specifically, the Navy
                     ordnance business area (1) did not accurately forecast the amount of work
                     to be performed, (2) used a pricing structure that did not allow individual
                     ordnance activities to charge customers prices that represented their
                     estimated cost of doing business, and (3) did not accurately budget and
                     account for costs, especially overhead costs, related to performing work.


                     Over the past several years, the difference between the budgeted DLHs and
More Reliable        the actual direct hours worked has varied widely. Because prices charged
Workload Estimates   Navy ordnance customers are based, in part, on the projected workload to
Are Needed           be performed, fluctuations in the amount of direct work and the type of
                     work performed have resulted in the losses. As discussed in chapter 3, the
                     loss of workload has caused substantial losses because it prevented the
                     business area from recovering its fixed overhead costs. In an attempt to
                     develop more reliable workload estimates, in 1995, the Navy ordnance
                     business area began contacting customers to determine if the customers
                     had identified any changes in the amount of work they expected to give to
                     the Navy ordnance business area. However, Navy ordnance officials
                     estimate that the workload forecast used to develop the fiscal year 1997
                     prices is overstated by 1.6 million DLHs, or 25 percent of the original
                     forecast. Until the Navy ordnance business area is able to more accurately




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                           forecast workload and properly size its workforce to the amount of work
                           it receives, the business area will continue to incur losses.


Workload Validations       The Navy ordnance business area began validating the workload estimates
Identified Many Problems   in 1995 because work was not showing up as the customers and the Navy
                           ordnance business area had planned. In 1995, the Navy ordnance business
                           area validated the fiscal years 1996, 1997, and 1998 workload estimates for
                           its major customers and, in 1996, they validated the fiscal years 1997, 1998,
                           and 1999 estimates. The 1995 and 1996 validations determined that the
                           Navy ordnance business area would not receive about 12 percent and
                           15 percent of the fiscal years 1996 and 1997 forecasted workload,
                           respectively.

                           Navy ordnance officials informed us that the major reason causing actual
                           workload to vary from budgeted workload is that they begin formulating
                           workload estimates 18 to 20 months before the start of the fiscal year. The
                           Navy Comptroller’s office and the Office of the Secretary of Defense adjust
                           the workload estimates with the final adjustments occurring about 9
                           months before the beginning of the fiscal year. In preparing the workload
                           estimates so far in advance, forecasts of the amount of work to be
                           received from customers are based on assumptions, and thus are not
                           always accurate. For example, (1) the Navy ordnance business area
                           finalizes its workload estimates before the customers’ budgets are
                           finalized, (2) the customers’ original estimates sometimes represent the
                           total unfunded workload requirements, or unconstrained requirements,
                           which are generally reduced in the budget process because of funding
                           limitations, (3) there is no formal commitment between the customer and
                           the Naval ordnance business area on the amount of work to be performed
                           when the budget estimates are developed, and (4) the customer is not
                           penalized if less work is ordered than originally planned. These workload
                           estimates are used in developing the prices that the business area will
                           charge its customers.

                           Based on the more recent workload shortfalls and the Navy ordnance
                           workload validations, the Navy ordnance business area has reduced the
                           workforce needed to accomplish work. For example, (1) during fiscal year
                           1995, the Navy ordnance business area reduced its workforce by 657
                           through voluntary separations and two reductions-in-force and (2) in fiscal
                           year 1996, the business area did not hire people even though it was
                           authorized to do so. However, the Navy ordnance business area has




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                            continued to be optimistic in estimating its workload. For example, about
                            600,000 DLHs of expected work did not materialize in fiscal year 1996.


Workload Forecasting        Workload not materializing as planned appears to be a significant problem
Continues to Be a Problem   again for fiscal year 1997. While the Navy ordnance business area
in Fiscal Year 1997         estimated that it would receive 6.3 million DLHs during fiscal year 1997, it
                            now believes that it will receive 4.7 million DLHs—a reduction of 25
                            percent. This has already drastically affected the operation of Navy
                            ordnance departments performing work. For example, in November 1996,
                            at one department of the Yorktown Naval Weapons Station which
                            employed 77 people, 33 people were charging time to overhead cost codes
                            even though they were originally budgeted to perform direct work.
                            Another department shifted 35 staff to overhead because they did not
                            receive work as planned. For example, this department anticipated
                            receiving only $5 million of the $11 million of air launch missile
                            maintenance work it had budgeted for in fiscal year 1997. This was a
                            55-percent reduction in planned workload.

                            Due to inaccurate forecasts of work to be performed, the Navy ordnance
                            business area is currently estimating that it will incur $66 million of losses
                            in fiscal year 1997. As discussed above, the workforce reductions have not
                            kept pace with the continuing decline in work. The lower-than-expected
                            workload levels forced the business area to shift many of its direct labor
                            employees to overhead positions and results in the business area
                            generating less revenue to cover fixed overhead costs. This, in turn, will
                            result in the Navy ordnance business area incurring additional losses in
                            fiscal year 1997. The Navy plans to reduce the Navy ordnance business
                            area workforce in fiscal year 1997 to better size it with its estimated
                            workload.


                            Prior to the establishment of NOC in fiscal year 1994, each weapons station
Uniform Price               charged customers a price for work performed that reflected the station’s
Structure Is                estimated costs to do the work, including a surcharge to recoup losses
Counterproductive to        from or return profits to their customers. When NOC was created, the Navy
                            replaced the individual station prices with a uniform price structure.
Efficient Operations        Under this structure, customers pay the same price for like work
                            regardless of (1) where the work is performed and (2) the individual
                            weapons station’s cost to perform the work. In addition, each weapons
                            station now shares equally in prior year losses/gains through a standard or
                            uniform surcharge that is included in the price charged customers. The



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                                      uniform price concept masks the individual weapons station’s
                                      performance on the monthly financial reports.

                                      The uniform price structure was instituted to help solidify the ordnance
                                      business area into a single entity and is not generally used by other depot
                                      maintenance business areas. Among other things, the Navy envisioned that
                                      uniform prices would discourage Navy ordnance activities from competing
                                      with each other for the same customer work and equally spread corporate
                                      infrastructure costs over the ordnance business area’s workload.

                                      However, the uniform price structure is not consistent with the basic tenet
                                      of a business operation and the reasoning behind the DBOF concept: that
                                      prices should reflect a specific activity’s actual costs of doing business.
                                      Instead, as discussed below, the practice of using a uniform price
                                      structure, and especially the practice of each station equally sharing
                                      losses, distorts the true results of a weapons station’s operations and
                                      makes it difficult for management to compare operational efficiencies
                                      between stations and/or evaluate a station’s performance over time. It also
                                      diminishes the incentive for a weapons station to operate efficiently.

                                      Table 4.1 shows the disparities between individual weapons station
                                      composite prices based on the estimated costs of doing business and the
                                      overall NOC composite price charged customers under the uniform price
                                      concept. For example, the Charleston Weapons Station was budgeted to
                                      make a profit of $13.25 for every DLH of work performed because its $75.78
                                      estimated cost per labor hour is less than the $89.03 estimated overall
                                      composite price per hour charged customers under the uniform price
                                      structure. Conversely, Earle was budgeted to lose $25.22 for every DLH of
                                      work performed because the uniform price precludes Earle from
                                      recovering its estimated costs of providing goods and services.

Table 4.1: Comparison of Individual
Weapons Station’s Composite Price                                     Individual
Per Hour to Overall NOC Composite                                weapons station        NOC overall
Price for Fiscal Year 1996                                       composite price     composite price
                                      Weapons station                   per hour           per hour          Difference
                                      Earle                               $114.25             $89.03            $(25.22)
                                      Yorktown                               99.61             89.03             (10.58)
                                      Concord                                91.69             89.03              (2.66)
                                      Seal Beach                             81.86             89.03               7.17
                                      Charleston                             75.78             89.03              13.25




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The uniform price concept does not allow the ordnance business area’s
monthly financial reports to present a true picture of a weapons station’s
financial performance and thus the operational efficiency of the station.
For example, the September 30, 1996, financial reports for the ordnance
business area showed that Charleston made a profit of $10 million.
However, Charleston was budgeted to make about $44 million, which
equates to a $34 million shortfall. Because of the uniform price structure,
the monthly financial reports make it appear that Charleston was
operating efficiently because the reports showed that the station’s
revenues exceeded its expenses.

Not only does the uniform price structure distort financial reporting, the
practice of requiring each weapons station to share equally in recovering
the ordnance business area’s overall accumulated operating losses in the
prices charged customers reduces an individual station’s incentive to
operate efficiently. Fiscal year-end 1995 financial reports for the ordnance
business area showed that the weapons stations’ individual accumulated
operating results ranged from a positive $6.2 million to a negative
$90.4 million, for an overall negative accumulated operating result of
about $217 million. Regardless of what activities made a profit or incurred
a loss, NOC included a surcharge of $8.28 per DLH in the fiscal year 1996
prices that each weapons station charged its customers. As long as a
weapons station can get its high-cost operations subsidized by lower cost
stations, the incentive to reduce costs and/or operate more efficiently is
significantly diminished.

In discussing the NOC’s uniform price structure with Office of the Secretary
of Defense (Comptroller) officials, they stated that although there is no
written policy regarding the price structure to be used by business areas,
the use of a uniform price is “irregular.” Specifically, business area
activities are supposed to charge customers prices that represent their
individual operating costs plus their fair share of the business area’s
overhead. NOC officials stated that the uniform price structure tends to
mask inefficient operations and diminishes the incentive to operate
efficiently. We believe that it is time for NOC to reconsider the uniform
price structure and return to separate prices based on the individual
activity’s costs of operations.




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                           Knowing the correct cost of operations, including both overhead and
Budgeting and              direct costs, is essential for managers to successfully manage business
Accounting for             operations and better control costs. However, we found that business area
Overhead Costs Are         managers do not have such data. Specifically, as discussed below, certain
                           budgeting and accounting practices make it difficult for ordnance
Neither Accurate Nor       managers to (1) ensure that customers only pay for services they receive
Consistent                 or benefit from and (2) assess the business area’s performance and
                           determine whether it is operating efficiently.


Inaccurate Allocation of   The Navy ordnance business area’s overhead costs have not been properly
Overhead Costs Benefits    matched with the appropriate workloads. Specifically, tens of millions of
Ammunition Storage and     dollars in overhead costs related to storing and distributing ammunition
                           are charged to other workloads, such as engineering and maintenance. As
Distribution Customers     a result of this inaccurate allocation of overhead costs, ammunition
                           storage and distribution customers pay less than they should for the
                           services they receive, while most other customers pay more than they
                           should.

                           Navy ordnance officials are aware of this problem and, in an attempt to
                           properly identify cost to the benefitting customers, performed a cost
                           restructuring study in which they analyzed the fiscal year 1996 overhead
                           costs for all their major programs. The study found that a substantial
                           amount of the overhead costs was directly related to the weapons stations’
                           basic mission of providing ammunition storage and distribution services to
                           Navy customers. Accordingly, Navy ordnance officials have identified the
                           costs that would remain if all other missions were eliminated. For
                           example, their analysis indicates that most costs related to such overhead
                           functions as inventory management, explosive safety, physical security
                           and fire protection will remain, even if all missions other than ammunition
                           storage and distribution are eliminated.

                           The cost restructuring study concluded, among other things, that
                           ammunition storage and distribution customers should be charged for
                           about $72 million in overhead costs that are currently charged to other
                           customers. For example, $42 million of overhead costs related to
                           underutilized plant capacity was allocated to all customers even though
                           these costs pertain to various ammunition storage and distribution
                           functions such as pier usage, ammunition storage, and the maintenance of
                           roads and railroads used to transport the ammunition.




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                             While the Navy has not approved this new approach, more accurately
                             allocating overhead costs yields two important benefits. First, it will better
                             match the overhead costs with the related work and, therefore, sales
                             prices will more accurately reflect the cost of doing the work. Secondly, it
                             will highlight the substantial cost associated with maintaining seven
                             separate Navy ammunition storage and distribution facilities.

                             However, if this cost restructuring initiative is implemented, the customer
                             would need additional appropriated funds to pay the price increases
                             related to the ammunition storage and distribution function. If the
                             customer does not receive these funds, there could be a readiness
                             problem. In fact, there are indications that budget constraints are already
                             creating problems in this area. For example, in an October 1996 message
                             to the business area’s Navy ammunition storage and distribution
                             customers, the NOC Commander pointed out that (1) as a result of budget
                             constraints, the Navy planned to fund only $91.8 million, or about
                             75 percent, of its fiscal year 1997 ammunition storage and distribution
                             requirement and (2) in prior years, the Navy has dealt with funding
                             shortfalls in this area by concentrating on loading and unloading ships,
                             and has neglected functions related to ammunition storage. The message
                             further stated that because of the funding shortfall, the Navy ordnance
                             business area will have problems loading ships during fiscal year 1997.


Distinction Between Direct   The Navy ordnance business area is not accurately budgeting and
and Overhead Costs Is        accounting for costs related to railroad operations. Naval Sea Systems
Blurred                      Command guidance entitled NAVSEA Navy Industrial Fund Financial
                             Management Systems and Procedures Manual is not clear on whether train
                             crews should be accounted for and budgeted as overhead. One section of
                             the guidance provides that the labor of individual employees which can be
                             identifiable with a specific service or a customer order be charged to
                             direct labor. However, another section of the guidance specifically states
                             that the pay of train crews be charged to overhead.

                             According to NOC officials, some weapons station’s railroads are used by
                             more than one customer. For example, the maintenance program at a
                             weapons station may use the trains to transport missiles to and from
                             storage in performing missile maintenance work. The officials stated that
                             railroad personnel are classified as indirect labor primarily because it is
                             difficult to allocate personnel costs to the various programs when more
                             than one ordnance program uses the trains. However, at the Earle
                             Weapons Station, railroad personnel costs are considered indirect even



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                      Information




                      though the railroad only performs services for one customer—the Receipt,
                      Segregation, Storage, and Issue program. Specifically, Earle has 15 people
                      in railroad operations performing services such as locomotive engineer
                      and conductor. Because railroad personnel are budgeted as indirect labor,
                      their costs are included in the overhead costs. This has the effect of
                      reducing the number of DLHs charged to the customer using the railroad
                      but increases the hourly labor rates charged that same customer.
                      Consequently, it leaves managers with an inaccurate picture of the actual
                      labor involved in providing a service that involves the trains transporting
                      ordnance.


                      Reliable and readily accessible financial management information is
Conclusions           essential to the effective and efficient operation of the Navy ordnance
                      business area. For a revolving fund operation, this would mean that
                      managers need to have accurate and consistent information on work to be
                      performed and that the price charged customers should reflect the cost of
                      doing business. However, the Navy ordnance business area (1) did not
                      accurately forecast the amount of work to be performed, (2) used a pricing
                      structure that kept individual ordnance activities from charging customers
                      prices that represented their estimated cost of doing business, and (3) did
                      not accurately and consistently budget and account for overhead costs,
                      especially overhead costs related to the ammunition storage and
                      distribution mission. These practices hamper management’s ability to
                      compare operational efficiencies between weapon stations, evaluate a
                      stations’s or the total business area’s performance over time, or reliably
                      estimate future operating results.


                      We recommend that the Secretary of the Navy direct the Navy ordnance
Recommendations       business area to discontinue the uniform price structure and develop
                      prices for individual Navy ordnance activities.

                      We also recommend that the Secretary of Defense and the Secretary of the
                      Navy

                  •   ensure that the workload used in developing prices at the individual Navy
                      ordnance activities are based on more realistic estimates by directing the
                      Navy ordnance business area to (1) continue to validate the workload
                      estimates with customers and (2) compare forecasted to actual work
                      (direct labor hours) received from customers and consider these trends in
                      developing the workload estimates and



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                     •   ensure that costs, especially overhead costs associated with the
                         ammunition storage and distribution mission, are accurately allocated to
                         the customers benefitting from the services.


                         DOD agrees with our two recommendations to (1) ensure that workload
Agency Comments          used in developing prices are based on more realistic estimates and
and Our Evaluation       (2) ensure that costs, especially overhead costs, are accurately allocated to
                         the customers benefitting from the services.

                         However, DOD did not concur at this time with our recommendation on
                         setting prices based on costs expected to be incurred by individual
                         activities. DOD cited the need to complete two initiatives in order to more
                         fully consider this recommendation. DOD plans to complete these
                         initiatives by August 1, 1997. DOD plans to address the desirability of
                         establishing individual activity prices as part of a DOD-wide study to
                         address the concerns that the Congress has on DOD Working Capital
                         Funds. The second initiative involves the Navy ordnance business area
                         changing its method of charging ammunition storage and distribution
                         customers. The Navy ordnance business area now plans to charge these
                         customers a cost per ton instead of a cost per direct labor hour, which
                         may result in a more valid comparison of the costs at each ordnance
                         activity.

                         In conducting these initiatives, DOD needs to consider the incentives that
                         individual activities have for operating efficiently and reducing costs. With
                         regard to the Navy ordnance business area, we believe that as long as NOC
                         retains its uniform price policy, relatively high cost weapons stations will
                         be able to get their operations subsidized by lower cost stations and
                         activities, and the incentive to reduce costs and/or operate more efficiently
                         is significantly diminished. For example, we found that the Naval Warfare
                         Assessment Division (NWAD), which has less overhead costs than the
                         weapons stations and has operated at a profit in recent years, was required
                         to increase its fiscal year 1997 prices from $60.38 an hour to $76.40 an
                         hour, or approximately 27 percent, in order to subsidize more costly
                         activities. Further, if NWAD streamlines its operations and makes a profit,
                         the benefit of this improved efficiency on its future sales prices will be
                         diluted because the savings will be shared with other activities. Under the
                         uniform price policy, if weapons stations collectively have
                         higher-than-expected costs, it is possible that NWAD could streamline its
                         operations and reduce its operating costs, yet still have to increase its
                         prices.



                         Page 45                                      GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I

Comments From the Department of Defense




             Page 46        GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I
Comments From the Department of Defense




Page 47                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I
Comments From the Department of Defense




Page 48                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I
Comments From the Department of Defense




Page 49                                   GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix II

Major Contributors to This Report


                       Gregory E. Pugnetti, Assistant Director
Accounting and         Ron L. Tobias, Senior Auditor-In-Charge
Information            William A. Hill, Senior Auditor
Management Division,   Larry W. Logsdon, Advisor
                       Darby W. Smith, Advisor
Washington, D.C.       Cristina Chaplain, Communications Analyst


                       Karl J. Gustafson, Senior Evaluator
San Francisco          Eddie W. Uyekawa, Senior Evaluator
Regional Office




(511357)               Page 50                                GAO/AIMD/NSIAD-97-74 Navy Ordnance
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