oversight

Defense Industry Restructuring: Cost and Savings Issues

Published by the Government Accountability Office on 1997-04-15.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Acquisition and Technology,
                          Committee on Armed Services, United States Senate




For Release on Delivery
Expected at
2:00 p.m., EDT
                          DEFENSE INDUSTRY
Tuesday,
April 15, 1997            RESTRUCTURING

                          Cost and Savings Issues
                          Statement of David E. Cooper, Associate Director,
                          Defense Acquisitions Issues, National Security and
                          International Affairs Division




GAO/T-NSIAD-97-141
               Mr. Chairman and Members of the Subcommittee:

               I am pleased to be here this afternoon to discuss our work on the costs
               and savings associated with defense industry restructuring. The issue of
               whether the Department of Defense (DOD) should be paying defense
               companies for restructuring costs associated with acquisitions and
               mergers has been a controversial one—and one that is not well
               understood.

               Today, I will provide a brief overview of

           •   DOD’s  decision to pay restructuring costs,
           •   the process DOD uses to ensure that paying restructuring costs is in the
               government’s best interest, and
           •   the amount and nature of costs that DOD has paid and estimates of savings
               it has realized.

               After this overview, I will provide details about each of these issues.


               Over the last several years, defense contractors have attempted to become
Overview       more efficient and competitive by such activities as closing or combining
               facilities and eliminating jobs. DOD has always paid for its share of the
               costs of these activities when they were undertaken as part of an internal
               restructuring by a single contractor. Until July 1993, however, DOD did not
               pay for restructuring costs on certain contracts transferred from one
               company to another company as a result of a business combination. At
               that time, DOD changed its practice and began allowing restructuring costs
               to be charged to these contracts as long as certain conditions were met.
               Principally, such costs were allowed as long as projected savings
               exceeded projected costs. The dollar impact of this decision may be less
               than some anticipated. DOD estimates that only 10 percent of the costs DOD
               had paid through September 1996 resulted from the change in practice.

               As of March 31, 1997, five combinations had gone through a certification
               process that is required before DOD pays restructuring costs. We recently
               completed an evaluation of four of the five certified combinations, as well
               as one additional combination that DOD included in its reports to Congress.
               Overall, we found that DOD estimated its share of projected restructuring
               costs was about $755 million, while its estimated share of the savings
               resulting from these combinations was at least $3.3 billion. At the time our
               review, the five business combinations had incurred about $849 million for



               Page 1                          GAO/T-NSIAD-97-141 Defense Industry Restructuring
                        a wide range of restructuring activities, with about 10 percent of these
                        costs being for benefits and services to laid-off workers. Services for
                        laid-off workers were also being funded by federal grants and through the
                        contractors’ normal overhead costs.

                        Through September 1996, DOD reported that it had paid $179.2 million in
                        restructuring costs while realizing $346.7 million in savings. In other
                        words, for every $1.00 DOD had paid in restructuring costs, it estimated
                        savings of $1.93 had been realized. However, it is extremely difficult to
                        trace restructuring savings into reduced contract prices because many
                        factors other than restructuring activities affect contract prices. Due to the
                        interest in this area, we plan to further explore whether restructuring
                        savings can be traced to reduced contract prices.

                        I would now like to go back and discuss each issue in a little more detail.


                        Defense contractors are restructuring and consolidating to become more
DOD’s Decision to Pay   efficient and competitive as defense business has declined over the last
Restructuring Costs     several years. Contractors, whether or not they are involved in an
                        acquisition or merger, have been closing facilities and disposing of assets;
                        eliminating jobs; relocating employees; and combining facilities and
                        operations. The costs incurred for such activities that are undertaken as
                        part of an internal restructuring effort can be charged to defense contracts
                        as long as the costs are allowable, allocable, and reasonable as required by
                        the Federal Acquisition Regulation (FAR).

                        Prior to July 1993, however, DOD did not permit contractors to charge
                        restructuring costs to flexibly priced1 contracts that were transferred2
                        from one defense contractor to another as a result of a business
                        combination, such as a merger or acquisition. The rationale was that DOD
                        should not have to pay more for its contracts merely because they were
                        transferred from one contractor to another as a result of a business
                        combination.

                        In response to industry requests, and in an effort to encourage
                        consolidation in the defense industry and thereby reduce contract costs,


                        1
                         Flexibly priced contracts refer to a family of contracts under which the total amount paid to a
                        contractor is dependent on the allowable costs the contractor incurs in performing the contract.
                        2
                         The transfer of contracts from one contractor to another involves a process called novation. The
                        novation process requires a written agreement executed by the buyer, the seller, and the government,
                        in which the government agrees to the transfer.



                        Page 2                                     GAO/T-NSIAD-97-141 Defense Industry Restructuring
                        DOD changed its long-standing practice. On July 21, 1993, the Under
                        Secretary of Defense for Acquisition issued a memorandum permitting
                        contractors to charge restructuring costs to transferred contracts if certain
                        conditions were met. For example, contractors could charge restructuring
                        costs if it was determined that the restructuring activities would likely
                        result in overall reduced costs to DOD. In other words, projected
                        restructuring savings were to exceed costs. The costs charged to
                        transferred contracts also had to comply with FAR requirements for
                        allowability, allocability, and reasonableness. For example, certain
                        organization costs, such as legal and consulting fees applicable to business
                        combinations, cannot be charged to a government contract.

                        Some believe that the July 1993 change added substantial costs to DOD’s
                        contracts. That does not appear to be the case. Through September 30,
                        1996, the Defense Contract Audit Agency (DCAA) estimated that DOD had
                        paid $179.2 million in restructuring costs. We asked DCAA to determine
                        how much of these costs resulted from the change in practice. DCAA’s work
                        shows that the July 1993 change added only $18 million, or about
                        10 percent, more in restructuring costs than DOD otherwise would have
                        paid. In other words, DOD would have reimbursed most of these costs even
                        if it had not changed its practice. The 10 percent in additional costs,
                        however, may not be the same for future business combinations because
                        of differences in the factors that determine the percentage, including the
                        mix of flexibly priced and firm fixed-price contracts and the period of time
                        required for certification.


                        Congressional concerns about safeguarding the government’s interest in
Process for             paying restructuring costs led to enactment of section 818 of the 1995 DOD
Safeguarding the        Authorization Act (Public Law 103-337). Section 818 prohibits DOD’s paying
Government’s Interest   restructuring costs until a senior DOD official certifies that projected
                        savings are expected to exceed restructuring costs and requires DOD to
                        submit annual reports to Congress that provide, among other things,
                        information on the payment of restructuring costs to defense contractors
                        involved in business combinations. Congress modified the authority for
                        paying such costs in section 8115 of the 1997 DOD Appropriations Act
                        (Public Law 104-208) by requiring that projected savings exceed costs by a
                        ratio of at least two-to-one on business combinations occurring after
                        September 30, 1996.




                        Page 3                          GAO/T-NSIAD-97-141 Defense Industry Restructuring
    In response to section 818, DOD issued regulations on the payment of
    restructuring costs.3 The regulations contain several features designed to
    protect the government’s interest. For example, contractors are required
    to prepare proposals containing projected restructuring costs and savings.
    DCAA is to audit the proposals and payment is to be authorized only after a
    high-level DOD official certifies that the projected savings should result in
    overall reduced costs to DOD.

    As of March 31, 1997, five business combinations had gone through the
    required certification process. These combinations were

•   the United Defense Limited Partnership (UDLP) between FMC
    Corporation’s Defense Systems Group and Harsco Corporation’s BMY
    Combat Systems Division,
•   Martin Marietta Corporation’s acquisition of General Electric Company’s
    aerospace and other business segments,
•   Northrop Corporation’s acquisitions of the Grumman Corporation and the
    Vought Aircraft Company to form the Northrop Grumman Corporation,
•   the merger of the Lockheed Corporation and the Martin Marietta
    Corporation to form the Lockheed Martin Corporation, and
•   Martin Marietta Corporation’s acquisition of General Dynamics’ Space
    System Division.

    We examined the process used to certify four of the business
    combinations and found that DOD complied with the restructuring
    regulations. We did not examine Martin Marietta’s acquisition of General
    Dynamics’ Space System Division because we were already examining two
    other business combinations involving Martin Marietta. For the
    combinations examined, the contractors submitted restructuring
    proposals with projected costs and savings; the proposed costs and
    savings were audited; and a senior DOD official certified that the projected
    savings should result in overall reduced costs to DOD.

    The Defense Contract Management Command told us that 10 additional
    business combinations either were in the certification process or may
    result in restructuring proposals. Appendix II provides additional
    information on these 10 combinations.



    3
     DOD issued interim regulations on the allowability of restructuring costs effective December 29, 1994.
    After evaluating public comments, DOD published the final regulations in the Federal Register dated
    April 18, 1996. Section 818 required us to report on the adequacy of the regulations, which we did in
    Defense Restructuring Costs: Payment Regulations Are Inconsistent With Legislation
    (GAO/NSIAD-95-106, Aug. 10, 1995).



    Page 4                                     GAO/T-NSIAD-97-141 Defense Industry Restructuring
                                        As you are aware, we issued a report earlier this month4 that contains
Amount and Nature of                    information on the projected and incurred restructuring costs for five
Estimated                               business combinations, including four of the five certified business
Restructuring Costs                     combinations, as well as Hughes Aircraft Company’s acquisition of
                                        General Dynamics Corporation’s Missile Operations. This combination did
                                        not have to go through the certification process because payment of the
                                        restructuring costs was approved before the 1995 DOD Authorization Act
                                        was passed; however, we included it in our review because DOD has
                                        included the combination in its restructuring reports to Congress.

                                        Overall, we reported that the projected restructuring costs for these five
                                        business combinations totaled about $1.4 billion. Because these costs will
                                        be allocated to all of the contractors’ customers, DOD’s portion of these
                                        costs will depend on its share of the contractors’ total business base.
                                        Consequently, DOD’s estimated share of the $1.4 billion totaled
                                        $755.2 million. Finally, we reported that the five business combinations
                                        had incurred costs of about $849 million for a wide range of restructuring
                                        activities, such as disposing of and modifying facilities, consolidating
                                        operations and systems, relocating workers and equipment, and
                                        eliminating jobs. We grouped the costs into several broad categories to
                                        illustrate their nature (see table 1).

Table 1: Incurred Restructuring Costs
by Category                             Dollars in millions
                                        Category                                                                             Amount
                                        Disposal and relocation of facilities and equipment                                   $452.7
                                        Relocation of employees                                                                100.0
                                        Benefits and services for laid-off workers                                              88.9
                                        Consolidation of operations and systems                                                 81.4
                                        Restructuring planning and implementation                                               57.8
                                        Other                                                                                   68.5
                                        Total                                                                                 $849.3

                                        Disposal and relocation of facilities and equipment was the largest
                                        category of incurred restructuring costs, amounting to over $450 million.
                                        Of the $88.9 million expended for benefits and services for laid-off
                                        workers, almost 90 percent was for severance pay, about 6 percent was for
                                        the temporary continuation of health benefits, and about 4 percent was for
                                        reemployment assistance.


                                        4
                                         Defense Restructuring Costs: Information Pertaining to Five Business Combinations
                                        (GAO/NSIAD-97-97, Apr. 1, 1997).



                                        Page 5                                   GAO/T-NSIAD-97-141 Defense Industry Restructuring
We also found that services for laid-off workers were being funded by
federal grants. We identified about $48 million in Department of Labor
grants made either directly to contractors or to locations where workers
were laid off as a result of the business combinations. These grants funded
activities to help workers seek new employment regardless of whether
they were laid off as a result of a business combination or normal
downsizing.

Of the $48 million in Department of Labor grants, about $17 million was
awarded directly to Hughes and Martin Marietta. We recommended in our
April 1997 report that the Secretary of Defense obtain information about
significant federal grants made directly to defense contractors and include
the information in the DOD reports submitted annually to Congress in
response to section 818 requirements. We believe including information
about Department of Labor grants would provide the Congress more
complete information about federal funding used to assist workers in
connection with defense contractor restructuring activities. In response to
our recommendation, DOD officials stated that they would meet with Labor
officials to determine how such information could be made available to
DOD for inclusion in its annual reports to Congress.


In addition to grant funds, contractors were providing some services and
charging them as normal overhead costs, rather than restructuring costs.
For example, UDLP operated an outplacement center where all terminated
employees, regardless of why they were laid off, could obtain assistance in
seeking a new job. UDLP spent $205,000 in operating the center over a
3-year period and paid an additional $109,000 to a consulting firm to assist
mid- and senior-level management officials seek new employment. UDLP
charged these costs to overhead rather than restructuring costs. Similarly,
Northrop Grumman and Lockheed Martin provided counseling and/or
outplacement assistance to help workers seek new employment and
charged the costs as overhead expenses rather than restructuring costs.

The process by which defense contractors are to be reimbursed for
restructuring costs differs from the typical contract payment process.
Normally, contractors are allowed to bill government contracts during the
same period they incur costs. That is not the case with restructuring costs.
Contractors are required to segregate restructuring costs in their
accounting records until the certification process I described earlier is
completed. After certification, contractors can begin charging
restructuring costs to DOD contracts. Contractors are generally permitted
to recover restructuring costs over a 5-year period, but the recoupment



Page 6                          GAO/T-NSIAD-97-141 Defense Industry Restructuring
                            period may be shorter, depending on the terms negotiated between DOD
                            and the contractor.

                            As I noted earlier, the five business combinations we examined incurred
                            about $849 million in restructuring costs and these costs will be allocated
                            to each of the contractors’ customers and paid over a period of time.


                            DOD expects the consolidation and restructuring occurring in the defense
Amount and Nature of        industry will reduce operating costs and thereby reduce contract costs.
Estimated                   However, estimating the savings DOD is likely to realize from restructuring
Restructuring Savings       activities is difficult. Unlike restructuring costs, restructuring savings are
                            not recorded in a contractor’s accounting records. Therefore, neither the
                            amount nor the nature of the savings can be determined by reviewing the
                            accounting records. Consequently, savings must be estimated.

                            For four of the business combinations we examined, certified
                            restructuring savings totaled about $5.3 billion, of which DOD’s estimated
                            share is $3.3 billion. These amounts do not include any savings from the
                            Hughes-General Dynamics business combination because the combination
                            occurred before Section 818 was enacted. Consequently, there is not a
                            certified amount of savings for that combination. Additionally, these
                            amounts do not include any savings resulting from Martin Marietta’s
                            acquisition of General Dynamics’ Space System Division since it was not
                            included within our review.

                            I would like to make the following three observations about restructuring
                            savings.

                        •   Certified savings are considerably less than the amounts often reported in
                            the media or proposed to DOD.
                        •   DOD estimated that it had realized net savings of $167.5 million as of
                            September 30, 1996.
                        •   It is extremely difficult to trace restructuring savings into reduced contract
                            prices.

                            Let me explain each of these points.

                            First, defense contractors, in announcing mergers or acquisitions,
                            generally provide initial estimates of savings expected to result from the
                            new business combinations. We have observed a tendency for these initial
                            estimates to be overly optimistic. For example:



                            Page 7                           GAO/T-NSIAD-97-141 Defense Industry Restructuring
•   In the case of UDLP, we found that the savings estimated at the time of
    DOD’s certification represented less than 15 percent of the estimate FMC
    and Harsco originally presented to DOD.5
•   In the case of Martin Marietta-General Electric, the savings estimates used
    for certification purposes were about 56 percent less than Martin
    Marietta’s original estimate.6
•   In the case of Lockheed Martin, the certified savings were less than half of
    Lockheed Martin’s initial proposal.

    There are various reasons for such differences, including reductions in
    estimated savings made by the contractors at the time they prepared their
    restructuring proposals and negotiated reductions in savings based on
    DCAA audits of the contractors’ proposals. Further, DOD limits savings for
    certification purposes to 5 years. In the case of Lockheed Martin,
    excluding savings projected beyond the 5-year limit was the principal
    reason for the difference between the amount Lockheed Martin initially
    proposed and the amount certified by DOD.

    Second, in terms of savings realized, DOD estimated that it had realized net
    savings of $167.5 million as of September 30, 1996. DOD’s estimate was
    based on paying restructuring costs totaling $179.2 million and realizing
    savings of $346.7 million. In other words, for every $1.00 DOD has paid in
    restructuring costs, it estimates savings of $1.93 have been realized. DOD
    officials noted that savings may actually be higher because DOD reviewed
    only eight contracts for the Hughes-General Dynamics business
    combination to demonstrate that savings exceeded costs.

    Finally, it is extremely difficult to trace restructuring savings into reduced
    contract prices because many factors other than restructuring activities
    affect contractor’s operations and costs. For example, changes in inflation
    rates, business volume, and accounting systems, as well as subsequent
    restructurings and unexpected events, all affect contract prices. When we
    attempted to identify reduced contract prices resulting from the UDLP
    business combination, we found differing views about the impact of the
    restructuring. At the time of our review, the Army had awarded UDLP only
    one new contract that was comparable to a contract awarded before
    restructuring. For that case, we concluded that UDLP’s restructuring efforts


    5
     Defense Contractor Restructuring: First Application of Cost and Savings Regulations
    (GAO/NSIAD-96-80, Apr. 10, 1996).
    6
     Our prior work on this combination covered the first eight certified projects. See Defense
    Restructuring Costs: Projected and Actual Savings From Martin-Marietta Acquisition of GE Aerospace
    (GAO/NSIAD-96-191, Sept. 5, 1996). We updated this figure to include all 13 certified projects.



    Page 8                                    GAO/T-NSIAD-97-141 Defense Industry Restructuring
contributed to a reduction in the contract price, but we could not
determine the precise amount. Due to the interest in this area, we plan to
further explore whether restructuring savings can be traced to reduced
contract prices.


Mr. Chairman, that concludes my statement. I will be glad to respond to
any questions you or members of the Subcommittee may have.




Page 9                         GAO/T-NSIAD-97-141 Defense Industry Restructuring
Appendix I

Selected Information on Cost and Savings
From Five Business Combinations


               Dollars in millions
               Certified amountsa                                                                         Amount
               Costs                                                                                      $1,373.9
               Savingsb                                                                                    5,257.0
               DOD share of certified amounts
               Costs                                                                                           755.2
                         b
               Savings                                                                                     3,304.6
               Status of September 30, 1996
               Restructuring costs paid by DOD                                                                 179.2
               Estimated savings realized by DOD                                                               346.7
               a
               Does not include any costs or savings resulting from Martin Marietta’s acquisition of General
               Dynamics’ Space System Division.
               b
                Does not include any savings from the Hughes-General Dynamics business combination since
               the combination occurred prior to the enactment of section 818 of the 1995 Department of
               Defense Authorization Act. Consequently, there is not a certified amount of savings for that
               combination.




               Page 10                                   GAO/T-NSIAD-97-141 Defense Industry Restructuring
Appendix II

Status of Selected Mergers Involving
Defense Contractors


Acquirer                             Target firm                        Date combined      Status of restructuring proposal
Combinations currently with proposals in the certification process
Westinghouse Electric                Norden Systems                     June 1994          Defense Contract Audit Agency
                                                                                           (DCAA) audit of proposal complete
Allied Signal                        Textron Lycoming                   October 1994       Awaiting completion of DCAA audit
Hughes                               CAE Link                           December 1994      DCAA audit completed
Litton                               Varo Night Vision division         June 1995          Awaiting completion of DCAA audit
Mergers that may result in restructuring proposals
Northrop Grumman                     Westinghouse Electronic Systems    March 1996         Not applicable
Lockheed Martin                      Loral                              April 1996         Not applicable
The Boeing Company                   Rockwell’s aerospace and defense   December 1996      Not applicable
                                     units
Proposed mergers awaiting regulatory approval
The Boeing Company                   McDonnell Douglas Corporation      To be determined   Not applicable
Raytheon Company                     Texas Instruments’ Defense         To be determined   Not applicable
                                     Systems & Electronics
Raytheon Company                     Hughes Electronics’ defense        To be determined   Not applicable
                                     business




(707251)                                     Page 11                         GAO/T-NSIAD-97-141 Defense Industry Restructuring
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