Air Force Depot Maintenance: Analysis of Its Financial Operations (Letter
Report, 12/10/1999, GAO/AIMD/NSIAD-00-38).

Pursuant to a congressional request, GAO provided information on the
financial operations of the Air Force depot maintenance activity group,
focusing on the: (1) Air Force depot maintenance activity group's price
increase between fiscal year (FY) 1994 and FY 1999 and the primary
reasons for it; (2) activity group's financial losses during FY 1994
through FY 1998 and the primary reasons for them; and (3) Air Force's
methods for recovering these losses.

GAO noted that: (1) the Air Force depot maintenance activity group's
prices increased from an average of $92.60 per direct labor hour (DLH)
in FY 1994 to $128.43 per DLH in FY 1999--a 39 percent increase; (2) the
price increase occurred primarily because: (a) the direct material cost
per direct labor hour increased; (b) workload declined faster than
overhead costs; and (c) the average cost of civilian labor increased;
(3) even though the prices increased 39 percent, the Air Force reported
that the depot maintenance activity group lost about $623 million during
fiscal years 1994 through 1998 on total sales of about $21.8 billion;
(4) GAO's analysis indicates that these losses occurred primarily
because the activity group: (a) did not accomplish as much work as
expected; (b) had material costs that were higher than budget estimates;
(c) developed prices based on anticipated savings that were not
realized; and (d) incurred losses on its contract repair operations
during fiscal years 1996, 1997, and 1998; (5) since FY 1995, the Air
Force has tried different methods to recover the depot maintenance
activity group's losses with varying success; (6) for fiscal years 1995
through 1997, the Air Force increased prices and requested a direct
appropriation; (7) however, neither of these methods was successful in
recouping losses; (8) beginning in FY 1998, the Air Force used two other
methods, which were more successful in recovering losses; (9) the Air
Force developed the depot maintenance activity group's fiscal years 1998
and 1999 prices based on the group's cost of operations plus an amount
to recover $310 million in prior year losses; (10) the Air Force then
separated the approved fiscal years 1998 and 1999 prices into two
pieces; (11) the first piece was the amount the activity group charged
individual customers for current year work; (12) the second piece was to
recover the $310 million in prior year losses; (13) pursuant to a new
Department of Defense policy that directs depot maintenance activities
to recover losses that occurred during the year of execution, the Air
Force reprogrammed funds and used other available customer appropriated
funds to recover the depot maintenance activity group's losses; and (14)
as a result, the Air Force recovered or plans to recover $313.4 million
in losses that occurred in fiscal years 1998 and 1999.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD/NSIAD-00-38
     TITLE:  Air Force Depot Maintenance: Analysis of Its Financial
	     Operations
      DATE:  12/10/1999
   SUBJECT:  Productivity in government
	     Equipment maintenance
	     Losses
	     Military cost control
	     Prices and pricing
	     Financial analysis
	     Labor costs
	     Future budget projections
	     Military appropriations
IDENTIFIER:  Air Force Working Capital Fund

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Report to the Chairman, Subcommittee on Military Readiness, Committee on
Armed Services, House of Representatives

December 1999

AIR FORCE DEPOT MAINTENANCE

Analysis of Its Financial Operations
*****************

*****************

GAO/AIMD/NSIAD-00-38

We issued two reports on the Navy Ordnance activity group (GAO/AIMD/NSIAD-
97-74, March 14, 1997, and GAO/AIMD/NSIAD-98-24, October 15, 1997) and two
reports on the 
Actual fiscal year 1999 data are a straight-line projection of actual data
for the first 
Prior to 1998 (1) the activity group paid the full (standard) price for
repairable items provided to contractors, (2) items at contractor plants
were valued at standard prices, and (3) the activity group was credited
for the carcass value (standard price less exchange price) when broken
items were returned to supply. Under the new policy (1) the activity group
pays the exchange price (standard price less carcass value) for items
provided to contractors, (2) the value of items at contractor plants is
based on exchange prices, and 
                                                 Accounting and Information
                                                        Management Division

B-283840

December 10, 1999

The Honorable Herbert H. Bateman
Chairman
Subcommittee on Military Readiness
Committee on Armed Services
House of Representatives

Dear Mr. Chairman:

The Air Force depot maintenance activity group supports combat readiness
by providing the depot repair services necessary to keep Air Force units
operating worldwide. The group repairs and overhauls a wide range of
assets including aircraft, missiles, aircraft engines, electronics,
avionics, software, and repairable inventory items for military services,
other government agencies, and foreign governments. For example, in fiscal
year 1998, the Air Force reported that the depot maintenance activity
group performed major overhauls on about 670 aircraft, overhauled about 
980 engines, and repaired more than 800,000 inventory items. The group
generates about $5 billion in annual revenue of which about $3.5 billion
comes from in-house repair and services and about $1.5 billion comes from
its contract repair operations.

This report, one in a series/Footnote1/ you requested on the financial
operations of the Department of Defense's (DOD) Working Capital Funds,
addresses the Air Force depot maintenance activity group. This group
operates under the working capital fund concept, where customers are to be
charged the anticipated actual costs of providing goods and services to
them. 

As requested, this report discusses (1) the Air Force depot maintenance
activity group's price increase between fiscal year 1994 and fiscal year
1999 and the primary reasons for it, (2) the activity group's financial
losses during fiscal year 1994 through fiscal year 1998 and the primary
reasons for them, and (3) the Air Force's methods for recovering these
losses. We briefed your office on the results of our work on September 15,
1999. As agreed, we are continuing our work and will evaluate the Air
Force's ability to develop accurate estimates for work to be accomplished,
material costs, and anticipated savings that were used in developing depot
maintenance prices.

Results in Brief

The Air Force depot maintenance activity group's prices increased from an
average of $92.60 per direct labor hour (DLH) in fiscal year 1994 to 
$128.43 per DLH in fiscal year 1999--a 39 percent increase./Footnote2/ The
price increase occurred primarily because (1) the direct material cost per
direct labor hour increased, (2) workload declined faster than overhead
costs, and (3) the average cost of civilian labor increased.

Even though the prices increased 39 percent, the Air Force reported that
the depot maintenance activity group lost about $623 million/Footnote3/
during fiscal years 1994 through 1998 on total sales of about $21.8
billion. Our analysis indicates that these losses occurred primarily
because the activity group (1) did not accomplish as much work as
expected, (2) had material costs that were higher than budget estimates,
(3) developed prices based on anticipated savings that were not realized,
and (4) incurred losses on its contract repair operations during fiscal
years 1996, 1997, and 1998.

Since fiscal year 1995, the Air Force has tried different methods to
recover the depot maintenance activity group's losses with varying
success. For fiscal years 1995 through 1997, the Air Force increased
prices and requested a direct appropriation. However, neither of these
methods was successful in recouping losses. Beginning in fiscal year 1998,
the Air Force used the following two other methods, which were more
successful in recovering losses.

o First, the Air Force developed the depot maintenance activity group's
  fiscal years 1998 and 1999 prices based on the group's cost of
  operations plus an amount to recover $310 million in prior year losses.
  The Air Force then separated the approved fiscal years 1998 and 1999
  prices into two pieces. The first piece was the amount the activity
  group charged individual customers for current year work. The second
  piece was to recover the $310 million in prior year losses. 

o Second, pursuant to a new DOD policy that directs depot maintenance
  activities to recover losses that occurred during the year of
  execution, the Air Force (1) reprogrammed funds and (2) used other
  available customer appropriated funds to recover the depot maintenance
  activity group's losses. As a result, the Air Force recovered or plans
  to recover $313.4 million in losses that occurred in fiscal years 1998
  and 1999. 

Background

The Air Force depot maintenance activity group is part of the Air Force
Working Capital Fund, a revolving fund that relies on sales revenue rather
than direct congressional appropriations to finance its operations.
Working capital funds are to (1) generate sufficient revenue to cover the
full costs of their operations and (2) operate on a break-even basis over
time--that is, not make a profit nor incur a loss.

The activity group generates revenue by billing customers at
predetermined, fixed prices as it performs specifically agreed-upon work
for those customers. The prices are to be based upon anticipated actual
costs. DOD customers primarily use operations and maintenance
appropriations to pay for the work. Payments from customers replenish the
Air Force Working Capital Fund's working capital, which is used to finance
subsequent operations. The activity group is expected to operate within
the revenue it generates. Conceptually, this provides an incentive to
control costs and maximizes efficiency. It is essential that the activity
group operates efficiently since every dollar spent inefficiently results
in fewer funds available for other defense spending priorities. 

Developing accurate prices is challenging since the prices are developed
about 2 years in advance of when the work is actually received and
performed. In essence, the activity group's budget development has to
coincide with the development of its group's customers' budgets so that
they both use the same set of assumptions. To develop prices, the activity
group estimates (1) labor, material, overhead, and other costs based on
anticipated demand for work as projected by customers, (2) total direct
labor hours for each type of work to be performed, such as aircraft,
engines, and repairable items, (3) the workforce's productivity, and 
(4) savings due to productivity and other cost avoidance initiatives.

Since the early 1990s, the depot maintenance activity group has undergone
downsizing, accomplished through annual reductions-in-force and "early
outs." For instance, from fiscal years 1992 through 1999, the Air Force
cut the activity group's workforce by 23 percent (7,000 workers). The
activity group was further affected by the work of the 1993 and 1995 Base
Realignment and Closure Commissions, which resulted in decisions to close
two of the Air Force's five air logistics centers and the Aerospace
Guidance and Metrology Center.

DOD and the Air Force have also made several major policy and other
changes that affected the depot maintenance activity group's costs,
prices, and work performed since the early 1990s. Air Force officials
stated that (1) both costs and the prices set to recover those costs have
been significantly affected by changes in the scope and mix of workload to
be performed and (2) the depot maintenance activity group's costs have
increased due to the aging of the aircraft and engines. Table 1 shows
these changes have occurred throughout the 1990s.

Table****Helvetica:x11****1:    Policy and Other Changes Affecting the
                                Depot Maintenance Activity Group's Prices,
                                Costs, and Workload

-----------------------------------------------------------------------
| Fiscal year : Policy and other changes                              |
|---------------------------------------------------------------------|
| 1992        : Establishment of the Defense Business Operations      |
|             : Fund required recovery of full costs in the           |
|             : activity group's prices.                              |
|---------------------------------------------------------------------|
| 1992 and    : The financing of repairable inventory items in the    |
| 1993        : stock fund increased the activity group's material    |
|             : costs because the group did not pay for these items   |
|             : prior to this change.                                 |
|---------------------------------------------------------------------|
| 1992        : In response to the declining force structure and      |
| through 1999: the increasing amount of work that is being           |
|             : contracted out, the Air Force reduced the number of   |
|             : activity group employees from about 31,000 in         |
|             : fiscal year 1992 to about 24,000 in fiscal year       |
|             : 1998. This affected the experience and skills of      |
|             : workers as well as the amount of work that could be   |
|             : performed by the depots.                              |
|---------------------------------------------------------------------|
| 1993 to 1997: The Air Force converted its existing three level      |
|             : depot maintenance operations (organization,           |
|             : intermediate, and depot) to two levels                |
|             : (organization and depot) for selected avionics and    |
|             : engine items. Since the engine work was very          |
|             : material intensive, the average material cost per     |
|             : hour and the average customer price per hour both     |
|             : increased.                                            |
|---------------------------------------------------------------------|
| 1993 to     : The process of closing two air logistics centers      |
| present     : and the Aerospace Guidance and Metrology Center and   |
|             : transferring their work to other sources of repair    |
|             : reduced both the amount of work performed and the     |
|             : productivity of the workforce at these activities.    |
|---------------------------------------------------------------------|
| 1998        : The Air Force changed the method of pricing           |
|             : inventory items sold to customers, including the      |
|             : depot maintenance activity group, which affected      |
|             : the group's material costs.                           |
|---------------------------------------------------------------------|
| 1998 and    : About one-third of the group's workload was           |
| 1999        : scheduled to be competed or realigned, which          |
|             : affected the location and the amount of work          |
|             : performed by the depots and resulted in a major       |
|             : hiring and training requirement at the gaining        |
|             : activities.                                           |
-----------------------------------------------------------------------

Scope and Methodology

To determine what factors caused the prices to increase between fiscal
year 1994 and fiscal year 1999, we obtained and analyzed budget documents
that provided information on cost factors, such as material costs,
overhead costs, and salaries used in developing the prices. We discussed
the reasons for the price increases with Air Force officials located at
headquarters and the Air Force Materiel Command.

To determine what factors caused the activity group to incur losses from
fiscal year 1994 through fiscal year 1998, we obtained and analyzed budget
documents and accounting information that provided information on budgeted
and actual direct costs, overhead costs, workload expressed in direct
labor hours (DLH), and productivity. When variances occurred between
budgeted and actual reported information, we met with responsible
budgeting and accounting officials to ascertain why there were differences
and how the differences resulted in losses. To determine how the Air Force
recovered the activity group's reported losses, we obtained budget and
accounting information on the amount of the losses and analyzed the
methods used by the Air Force to finance those losses. We discussed the
different methods for recovering losses with Air Force officials located
at headquarters and the Air Force Materiel Command to determine why they
used several different methods.

We did not verify the accuracy of the accounting and budget information
used in the tables and charts in this report, all of which was provided by
the Air Force in then-year dollars. We are continuing our work and will
report separately on the Air Force's ability to develop accurate estimates
of workload, material costs, and anticipated savings that were used in
developing depot maintenance prices.

We performed our work at the headquarters, Office of the Under Secretary
of Defense (Comptroller) and the Office of the Secretary of the Air Force,
Washington, D.C.; Air Force Materiel Command, Dayton, Ohio; the Oklahoma
City Air Logistics Center, Tinker Air Force Base, Oklahoma; the Ogden Air
Logistics Center, Hill Air Force Base, Utah; the San Antonio Air Logistics
Center, Kelly Air Force Base, Texas; the Sacramento Air Logistics Center,
McClellan Air Force Base, California; the Warner Robins Air Logistics
Center, Robins Air Force Base, Georgia; and the Defense Finance and
Accounting Service, Arlington, Virginia. 

Our work was performed from May 1999 through October 1999 in accordance
with generally accepted government auditing standards. We requested
comments on a draft of this report from the Secretary of the Air Force or
his designee. On November 10, 1999, the Depot Maintenance Program Manager
provided us with oral comments. These comments are discussed in the
"Agency Comments" section of this report.

Factors Causing Prices to Increase

The depot maintenance activity group's composite sales price/Footnote4/
increased from $92.60 per DLH in fiscal year 1994 to $128.43 per DLH in
fiscal year 1999, an increase of about 39 percent./Footnote5/ As shown in
table 2 and discussed below, almost all of this price increase can be
attributed to three factors: (1) direct material costs per DLH increased,
(2) workload declined more rapidly than overhead costs and, as a result,
more overhead costs had to be allocated to each DLH of work accomplished,
and (3) the average cost of civilian labor increased.

Table****Helvetica:x11****2:    Primary Reasons for the Air Force Depot
                                Maintenance Activity Group's Fiscal Years
                                1994 and 1999 Sales Price Increase

-----------------------------------------------------------------------
| Reason                          :  Increase in the  :  Percent of   |
|                                 :     price per DLH :        total  |
|---------------------------------------------------------------------|
| Direct material cost per DLH    :            $14.28 :         39.8  |
| increased                       :                   :               |
|---------------------------------------------------------------------|
| Workload declined faster than   :           $13.01a :         36.3  |
| overhead costs                  :                   :               |
|---------------------------------------------------------------------|
| Average cost of civilian labor  :             $7.76 :         21.7  |
| increased                       :                   :               |
|---------------------------------------------------------------------|
| Other                           :              $.78 :          2.2  |
|---------------------------------------------------------------------|
| Total                           :            $35.83 :        100.0  |
-----------------------------------------------------------------------

aThe actual increase was $16.04 per hour, but $3.03 is not included
because it resulted from an increase in the average cost of civilian labor
(which is a separate reason).

Direct Material Costs Have Increased
------------------------------------

Our analysis showed that the depot maintenance activity group's budgeted
direct material costs have declined much less than its budgeted workload.
Specifically, the activity group's workload (expressed in DLHs) declined
nearly 35 percent between fiscal year 1994 and fiscal year 1999 due to
reductions in the Air Force's force structure, along with other factors
such as the increased use of contractors. However, its direct material
costs declined less than 4 percent. As a result and as shown in table 3,
direct material costs per DLH increased $14.28, about 48 percent.

Table****Helvetica:x11****3:    Budgeted Direct Material Costs per DLH for
                                Fiscal Year 1994 and Fiscal Year 1999

------------------------------------------------------------------------
|                          :   Fiscal year    :        Change          |
|----------------------------------------------------------------------|
| Description              :    1994 :   1999 :    Amount :   Percent  |
|----------------------------------------------------------------------|
| Direct material costs    : $1,029.7: $992.2 :  $(37.50) :     (3.6)  |
| (in millions)            :         :        :           :            |
|----------------------------------------------------------------------|
| DLHs (in millions)       :  34.421 : 22.451 :   (11.97) :    (34.8)  |
|----------------------------------------------------------------------|
| Direct material costs/DLH:  $29.91 : $44.19 :    $14.28 :      47.7  |
------------------------------------------------------------------------

Air Force depot maintenance officials stated that the increase in budgeted
direct material costs per DLH can be attributed to (1) higher material
costs and (2) increased material usage. Further, they stated that there is
more than one underlying cause for both of these factors. Part of the cost
increase can be attributed to inflation. Most of it, however, is
attributable to the fact that, in 1998, the Air Force supply management
activity group began charging specific customers the full cost of
replacing condemned inventory items (broken items that cost more to fix
than to replace). In the past, these costs were spread evenly to all
customers. According to 
Air Force officials, the net effect of this change was that some costs
shifted from other supply management activity group customers, such as Air
Force units, to the depot maintenance activity group. 

Air Force depot maintenance officials also stated that material usage has
increased because (1) the workload mix now includes more work that has
relatively high material costs/Footnote6/ and (2) factors such as the
aging of the aircraft and engine inventory is causing them to replace more
component parts when repairs are accomplished. However, these depot
maintenance officials acknowledge that they (1) do not yet fully
understand the effect of the various factors that have affected their
material costs in recent years and (2) need to develop a better
understanding of these factors if they are to effectively manage their
material costs. They also said that the Air Force is making a concerted
effort to develop this better understanding.

Workload Decline Has Outpaced Overhead Reduction
------------------------------------------------

Reductions in the Air Force's force structure, along with other factors
such as increased use of contractors, have reduced the amount of work
accomplished by the depot maintenance activity group's depots. However,
the depots' overhead costs have not decreased proportionately to the
decline in the workload. As a result, the depots have had to allocate more
overhead costs to each DLH of work they accomplished. Specifically, as
summarized in table 4, the need to allocate overhead costs over a steadily
declining workload base has caused the amount of budgeted overhead costs
allocated to each budgeted DLH of work accomplished to increase from
$33.38 in fiscal year 1994 to $49.42 in fiscal year 1999, an increase of
about 48 percent.

Table****Helvetica:x11****4:    Budgeted Overhead Cost per DLH for Fiscal
                                Year 1994 and Fiscal Year 1999

---------------------------------------------------------------------------
|                        :                       :        Change          |
|-------------------------------------------------------------------------|
| Description            :    Fiscal :    Fiscal :    Amount :   Percent  |
|                        : year 1994 : year 1999 :           :            |
|-------------------------------------------------------------------------|
| Overhead costs (in     :  $1,149.1 :  $1,109.5 :  $(39.60) :     (3.4)  |
| millions)              :           :           :           :            |
|-------------------------------------------------------------------------|
| DLHs (in millions)     :    34.421 :    22.451 :   (11.97) :    (34.8)  |
|-------------------------------------------------------------------------|
| Overhead cost/DLH      :    $33.38 :    $49.42 :   $16.04  :      48.1  |
---------------------------------------------------------------------------

According to Air Force depot maintenance officials, prices in general and
overhead cost in particular should decline after July 2001, when the 
Air Force expects to finish closing two depots and transferring their
workload to other depots and contractors.

Average Cost of Civilian Labor Has Increased 
---------------------------------------------

An increase in the average cost of civilian labor increased the depot
maintenance activity group's prices by $7.76 per DLH for fiscal year 1994
through fiscal year 1999, about $3.03 for overhead labor and $4.73 for
direct labor. This increase was due to higher costs for both salaries and
benefits. Specifically, as shown in table 5,

o budget estimates for the average annual cost of employee compensation
  (for basic salary and such variable costs as holiday and overtime pay)
  increased by $5,752 per work year per employee, 15.5 percent over 
  5 years and

o budget estimates for the average annual cost of employee benefits
  (employer contributions for such things as health and life insurance)
  increased by $2,147, or 29.1 percent over 5 years.

Table****Helvetica:x11****5:    Average Budgeted Cost of Civilian Labor
                                for Fiscal Year 1994 and Fiscal Year 1999

-------------------------------------------------------------------------
|                        :          :           :        Change         |
|-----------------------------------------------------------------------|
| Description            :   Fiscal :    Fiscal :    Amount :  Percent  |
|                        :     year :      year :           :           |
|                        :          :           :           :           |
|                        :     1994 :      1999 :           :           |
|-----------------------------------------------------------------------|
| Average employee       :  $37,175 :   $42,927 :    $5,752 :     15.5  |
| compensation           :          :           :           :           |
|-----------------------------------------------------------------------|
| Average employee       :   $7,375 :    $9,522 :    $2,147 :     29.1  |
| benefits               :          :           :           :           |
|-----------------------------------------------------------------------|
| Average compensation   :  $44,550 :   $52,449 :    $7,899 :     17.7  |
| and benefits           :          :           :           :           |
-------------------------------------------------------------------------

Factors Contributing to the Activity Group's Financial Losses

The Air Force depot maintenance activity group reported that it lost about
$623 million from fiscal years 1994 through 1998. Although many factors
contributed to these financial losses, our analysis indicates that they
occurred primarily because (1) the activity group did not accomplish as
much work as expected (budgeted) and was, therefore, unable to fully
recover its fixed overhead costs, (2) material costs were higher than
budget estimates, (3) prices were based on anticipated savings that were
subsequently determined by the Air Force to be overly optimistic, and 
(4) the activity group incurred losses on its contract repair operations
during fiscal years 1996, 1997, and 1998.

Projected Operating Results Have Consistently Been Overly Optimistic
--------------------------------------------------------------------

DOD policy requires that the depot maintenance activity group operate on a
break-even basis over time. However, from fiscal year 1994 through fiscal
year 1998, the activity group incurred losses every year. The activity
group did not achieve its goal of operating on a break-even basis during
this period chiefly because it consistently developed overly optimistic
estimates for the activity group's net operating results. For example, the
activity group was budgeted to earn a profit of about $200.1 million in
fiscal year 1998./Footnote7/ However, instead of making a profit, the
activity group reported that it lost about $35 million during the year.
Figure 1 shows the activity group's reported net operating results for
fiscal years 1994 through 1998.

Figure****Helvetica:x11****1:    Air Force Depot Maintenance Activity
                                 Group's Reported Actual Net Operating
                                 Results for Fiscal Years 1994 Through
                                 1998
*****************

*****************

Lower Than Budgeted Production Levels Prevented Full Recovery of Overhead
Costs
---------------------------------------------------------------------------

The Air Force depot maintenance activity group lost about $374 million
from fiscal years 1994 through 1998 because its workers accomplished fewer
DLHs of work than budgeted and because this, in turn, prevented it from
fully recovering its overhead costs. Air Force depot maintenance officials
stated the following.

o Overhead costs for such things as the salaries of administrative
  personnel are generally fixed costs in the year of execution and
  therefore do not vary significantly with the amount of work
  accomplished during the year.

o When prices are developed approximately 2 years in advance of actual
  work being accomplished, overhead costs are allocated on a prorated
  share to each DLH of work expected to be accomplished in the year of
  execution (i.e., in essence, each hour of work they accomplish pays for
  a certain amount of overhead costs). When workload does not
  materialize, regardless of the reason, DOD's price stabilization policy
  prohibits the activity group from increasing prices to make up for the
  shortfall.

Figure 2 shows that the number of budgeted DLHs declined from 
34.4 million in fiscal year 1994 to 25.3 million in fiscal year 1998--a 
9.1 million (26 percent) DLH reduction. Even though the Air Force reduced
the budgeted DLHs each year from fiscal year 1994 through fiscal year
1998, our analysis showed that the amount of work actually accomplished
during this 5 year period was still 10.1 million DLHs less than the
budgeted amount. Figure 2 shows the budgeted and actual DLHs for the 5-
year period.

Figure****Helvetica:x11****2:    Depot Maintenance Activity Group's
                                 Budgeted and Actual Production for Fiscal
                                 Years 1994 Through
                                 1998
*****************

*****************

Activity Group Had Higher Than Budgeted Material Costs
------------------------------------------------------

The activity group's reported actual material cost per DLH was 
$16.61, about 38 percent higher in fiscal year 1998 than the previous
fiscal year. Further, as shown in figure 3: (1) in fiscal year 1998, the
reported actual material cost per DLH was $12.40, about 26 percent higher
than the budgeted amount and (2) although the Air Force increased the
budget estimate for material cost per DLH by $5.96 in fiscal year 1999,
the reported actual costs have been even higher./Footnote8/ According to
Air Force officials, these increases were driven by a number of changes in
the Air Force's pricing policy for depot-level repairables in order to
more accurately distribute costs to customers. The changes had the net
effect of distributing a larger share of material cost to depot
maintenance and a smaller share to other Air Force activities.

Figure****Helvetica:x11****3:    Air Force Depot Maintenance Activity
                                 Group's Budgeted and Reported Actual
                                 Material Costs per DLH for Fiscal Years
                                 1997 Through
                                 1999
*****************

*****************

The higher than budgeted material cost per DLH caused the activity group's
fiscal year 1998 material costs to be $324 million higher than budget
estimates./Footnote9/ However, material costs per DLH of work accomplished
vary significantly from one workload to another, and a determination of
the effect of these higher material costs on the activity group's
financial operating results would require a detailed analysis of
individual workloads.

Recognizing that this is an area that needs more management attention, the
Air Force Materiel Command is beginning to implement metrics to develop a
better understanding of why material costs are increasing and how the
Command can better control and reduce material costs. This is a good step
toward ensuring that decisionmakers have the information they need to
manage the activity group as a business operation. 

Anticipated Budget Savings Did Not Materialize
----------------------------------------------

Another major contributor to the activity group's financial losses has
been its failure to achieve cost reduction and productivity improvement
goals that were incorporated into budget estimates. We could not determine
how much the activity group actually saved on individual initiatives
because activity group managers do not track and document actual
savings./Footnote10/ However, a comparison of initial budget estimates for
savings (which are used to develop prices) and revised budget estimates
provides a good indication that the savings are not being achieved.
Specifically, as shown in figure 4, in recent years, the initial budget
estimate for savings has repeatedly been reduced in the revised budget
estimate, which is developed the following year based on updated
information.

Figure****Helvetica:x11****4:    Comparison of Initial and Revised Budget
                                 Estimates for the Air Force Depot
                                 Maintenance Activity Group's Savings for
                                 Fiscal Years 1996 Through
                                 1998
*****************

*****************

Contract Operations Have Lost Money in Recent Years
---------------------------------------------------

As shown in figure 5, the activity group's contract operations reported a
net operating loss of about $210 million during fiscal years 1994 through
1998, a profit of about $21 million during the first 2 fiscal years, and a
loss of 
$231 million during the last 3 fiscal years.

Figure****Helvetica:x11****5:    Air Force Depot Maintenance Activity
                                 Group's Reported Actual Net Operating
                                 Results From Its Contract Operations for
                                 Fiscal Years 1994 Through
                                 1998
*****************

*****************

Although figure 5 indicates that the activity group's financial
performance on its contract operations has declined steadily since fiscal
year 1995, the results are distorted by a $98.8 million "accounting" loss
in fiscal year 1998. This loss occurred because the Air Force changed its
accounting policy on valuing inventory located at contractor plants and
inventory in transit from the contractors to the Air Force./Footnote11/
Since this loss was due to the revaluation of inventory and not due to
actual losses resulting from operations, the Air Force, with Office of the
Under Secretary of Defense (Comptroller) approval, did not recover this
loss in its prices. Without this change in accounting policy, the reported
fiscal year 1998 loss would have been 
$22.8 million rather than $121.6 million.

Most of the activity group's other contract losses were caused by problems
related to the management and control of government-furnished material
provided to contractors. For example, one air logistics center lost about
$18.8 million on a single contract because of numerous material-related
control problems, including (1) Air Force records showed that more
material was shipped to a contractor than was received by the contractor
and (2) material that was supposed to be on hand at the contractor's
facilities was not found.

Air Force Has Tried Different Methods to Recover Activity Group Losses

Over the last 5 years, the Air Force has tried four different methods to
recover the activity group's losses. For fiscal years 1995 and 1996,
prices the group charged individual customers for work were increased to
recover losses. For fiscal year 1997, rather than increase prices, the Air
Force requested an appropriation to recover losses but the request was
denied by the Congress. In fiscal years 1998 and 1999, the Air Force used
two different methods to recover the activity group's losses. First, the
Air Force separated approved customer prices into two pieces: an amount
charged individual customers for work performed in the current year and an
amount used to recover $310 million in prior year losses. Under the second
method, the activity group recovered or plans to recover $313.4 million in
losses in the fiscal year they occurred. Air Force officials told us that
the activity group will have about $30.5 million in accumulated operating
losses at the end of fiscal year 1999. These losses occurred during fiscal
year 1999 (primarily in the last quarter) and the Air Force plans to
recover them during fiscal year 2000.

Fiscal Years 1995 and 1996 Prices Increased to Recover Losses
-------------------------------------------------------------

DOD policy/Footnote12/ requires depot maintenance activities, as well as
other working capital fund activities, to operate on a break-even basis
over time. To do this, working capital funds are to establish prices that
would allow them to recover from their customers the expected costs of
operations, as well as any prior years' losses. In accordance with this
policy, the Air Force increased the activity group's fiscal years 1995 and
1996 customer prices in an attempt to recover prior year losses. However,
even though the prices were increased, the activity group reported losses
of about $86 million and $78 million in fiscal years 1995 and 1996,
respectively.

Appropriation of $194.5 Million Requested in Fiscal Year 1997 to Recover
Losses
---------------------------------------------------------------------------

Although the general practice has been to recover losses through
increasing the prices charged customers, DOD policy also allows losses to
occasionally be recovered by a direct appropriation. In its fiscal year
1997 budget submission to the Congress, rather than increasing prices, the 
Air Force requested that $194.5 million be appropriated to its Operations
and Maintenance account to specifically recover the activity group's
accumulated operating losses. The Operations and Maintenance funds were
then to be transferred (called a pass through) to the activity group.

In its budget submission to the Congress, the Air Force stated that the
requested appropriation was necessary to reduce the impact of external
events that were beyond its control on the activity group's prices. The 
Air Force stated that the DOD force structure reduction initiatives caused
workforce turmoil (unexpected workload losses, skilled labor imbalances,
and multiple job changes) that undercut budgeted productivity and
efficiency goals. The Air Force further stated that the $194.5 million
pass through was essential to the liquidity of its working capital fund
and protected customers from unacceptable future price increases.

The Congress denied the Air Force's request for the pass through. In
reviewing the request, the House Appropriations Committee stated that DOD
has had a policy of recovering prior year operational losses through
adjustments (increases) in prices. The Committee further stated that it
generally supported the policy of recovering losses through prices, and
since DOD requested a pass through to recover losses, the Committee was
concerned that DOD may be making a significant shift in policy. The
Congress subsequently reduced the Air Force's fiscal year 1997 budget
submission by the $194.5 million requested.

Prior Year Losses Recovered by Separating Fiscal Years 1998 and 1999
Prices Into Two Pieces
---------------------------------------------------------------------------

Activity group customer prices that were approved by DOD for fiscal years
1998 and 1999 and submitted to the Congress in the Air Force's budget
justification books included an amount to recover $310 million in prior
year losses. According to Air Force officials and budget documents, these
losses were related to the closing of two depot maintenance activities 
(San Antonio and Sacramento) and force structure reductions. To ensure
that the prior year losses were recovered, the Air Force separated the
group's approved prices into two pieces. The first piece was the amount or
price the group charged customers for current year work. The second piece--
the difference between the approved price and the actual price charged
customers--was the amount to be used to recover the $310 million in prior
year losses in fiscal years 1998 and 1999.

The funds representing the difference between the approved prices and the
prices actually charged customers--$176 million to be recovered in fiscal
year 1998 and $134 million to be recovered in fiscal year 1999--were
accounted for at Air Force headquarters and have been or will be provided
to the depot maintenance activity group. The Air Force sent project orders
to the activity group to recover these losses. By using this method, the
Air Force was able to help ensure that the activity group received or will
receive the funds to recover the prior year losses.

Losses Recovered in the Fiscal Year They Occurred
-------------------------------------------------

For many years, DOD has had a policy of recovering prior year losses
through increased customer prices for future work. Starting in fiscal year
1998, DOD changed this policy for its depot maintenance activities. DOD
now requires unbudgeted losses to be recovered in the year they occur by
adding a surcharge to individual customer's bills. An unbudgeted loss is
the difference between a depot maintenance activity's net operating
results that were estimated in its budget and the actual net operating
results experienced in the current year.

DOD changed its policy because it believed this would (1) encourage depots
to initiate cost controls more rapidly, (2) provide the right incentives
to set prices correctly, and (3) eliminate the routine use of advance
billing to cover execution losses./Footnote13/ This policy helps to
control costs because it puts pressure on the Air Force to ensure that the
depot maintenance activity group sets prices correctly. 

The Air Force followed DOD's policy change in fiscal years 1998 and 1999,
and as a result, its depot maintenance activity group collected or plans
to collect $313.4 million from customers to recover unbudgeted losses
during these 2 fiscal years--$182.6 million and $130.8 million in fiscal
years 1998 and 1999, respectively. However, rather than adding a surcharge
to customers' bills as required by DOD's new policy, the Air Force used
project orders to specifically recover the losses. Customers (major
commands) sent project orders to the depot maintenance activity group
which then, in turn, billed for the amount on the orders to recover the
losses.

To help Air Force customers pay the activity group their portion of the
losses related to current year work orders, the Air Force transferred 
$134.6 million in fiscal year 1998 and $80.5 million in fiscal year 1999
from its Procurement, Military Personnel and/or Research, Development,
Test and Evaluation appropriations to Air Force customers' Operations and
Maintenance appropriation. According to Air Force officials, the remaining
$98.3 million in unbudgeted losses was related to prior year orders, the
work for which was performed in the current year. To pay the activity
group for these losses, Air Force customers used prior year funds that
financed the orders that were still available for obligation.

Conclusions

Over the past 5 years, the Air Force depot maintenance activity group has
not been able to meet its financial goal of operating on a break-even
basis. Even though the activity group increased its prices 39 percent, the
activity group reported losses of $623 million. These losses primarily
occurred because the Air Force did not develop accurate estimates of its
expected material costs, direct labor hours to be performed, and
anticipated savings that were used in developing prices. Beginning in
fiscal year 1998, the 
Air Force began recovering losses in the year that they occurred. As a
result, the activity group will be closer to breaking even at the end of
fiscal year 1999 than it has in the past 5 years. 

The Air Force is also beginning to implement management metrics to develop
a better understanding of why material costs are increasing and how they
can be better controlled. While this is a good step toward ensuring that
decisionmakers have the information they need to manage the activity group
as a business operation, it will be important for the group to also
develop metrics for other key factors such as workload, overhead costs,
and anticipated savings. Our subsequent review will assess the
effectiveness of existing metrics and provide additional perspective on
the need for other measures.

Agency Comments

Air Force officials provided comments on previous briefings on the results
of our work. These comments were incorporated in this report as
appropriate. In providing oral comments on this report, Air Force
officials agreed with our findings and conclusions.

We are sending copies of this report to Representative Solomon P. Ortiz,
Ranking Minority Member, Subcommittee on Military Readiness, House
Committee on Armed Services; Senator John Warner, Chairman, and Senator
Carl Levin, Ranking Minority Member, Senate Committee on Armed Services;
Senator Ted Stevens, Chairman, and Senator Daniel K. Inouye, Ranking
Minority Member, Subcommittee on Defense, Senate Committee on
Appropriations; and Representative Jerry Lewis, Chairman, and
Representative John P. Murtha, Ranking Minority Member, Subcommittee on
Defense, House Committee on Appropriations. We are also sending copies of
this report to the Honorable William S. Cohen, Secretary of Defense, and
the Honorable F. Whitten Peters, Secretary of the Air Force. Copies will
also be made available to others upon request. If you have any questions
about this report, please call Mr. Greg Pugnetti, Assistant Director, at
(202) 512-6240. Other key contributors to this report are listed in
appendix I.

Sincerely yours,
*****************

*****************

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

*****************

*****************

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

--------------------------------------
/Footnote1/-^Air Force Supply Management Activity Group (GAO/AIMD/NSIAD-98-
  118, June 8, 1998, and GAO/NSIAD/AIMD-99-77, April 29, 1999).
/Footnote2/-^If the fiscal year 1994 price is converted to fiscal year
  1999 dollars, it would be $106.58 per DLH. This would reduce the
  increase to 20.5 percent.
/Footnote3/-^The $623 million loss includes a $98.8 million accounting
  adjustment that does not need to be recovered.
/Footnote4/-^The composite sales price is the average price that customers
  must pay for a DLH of work.
/Footnote5/-^The fiscal year 1994 information is in then-year dollars. If
  the fiscal year 1994 price is converted to fiscal year 1999 dollars, it
  would be $106.58 per DLH. This would reduce the increase to 20.5 percent.
/Footnote6/-^For example, engine work, which has higher material costs
  than most workloads, increased from 5.6 percent of the budgeted total in
  fiscal year 1994 to 12.5 percent in fiscal year 1999.
/Footnote7/-^This budget was submitted to the Congress in February 1997.
/Footnote8/-^10 months.
/Footnote9/-^Reported actual material costs were $360.8 million higher
  than the budgeted amount, but part of the difference was due to higher
  than budgeted production.
/Footnote10/-^Our report, entitled Air Force Depot Maintenance: Management
  Changes Would Improve Implementation of Reform Initiatives (GAO/NSIAD-99-
  63, June 25, 1999), discussed that the Air Force does not have a system
  for tracking savings.
/Footnote11/-^(3) the activity group receives no credit when contractors
  return broken items to supply.
/Footnote12/-^DOD's Financial Management Regulation, Volume 11B,
  Reimbursable Operations, Policy and Procedures--Defense Business
  Operations Fund, Chapter 50, page 50-2.
/Footnote13/-^Since 1993, the defense working capital funds have
  experienced a cash shortage and have had to advance bill customers for
  work not yet performed in order to ensure that the funds' cash balances
  remained positive.

GAO STAFF ACKNOWLEDGEMENTS
==========================

Cristina Chaplain, Karl J. Gustafson, William A. Hill, Ron L. Tobias, and
Eddie W. Uyekawa made key contributions to this report.

(511663 and 709418)

*** End of document. ***