Navy Ordnance: Analysis of Business Area Price Increases and Financial
Losses (Chapter Report, 03/14/97, GAO/AIMD/NSIAD-97-74).

The Navy ordnance business area increased prices 78 percent from fiscal
years 1994 through 1996 and incurred about $212 million in losses during
that same period. Most of these losses were due to actual overhead costs
exceeding budgeted overhead costs. This situation has led to significant
price increase that ultimately reduce purchasing power for the military
services' operations and maintenance appropriation dollars. GAO is
concerned that excessive operating costs may exist in many of the
Defense Department's (DOD) logistics business activities and may be
causing operations and maintenance appropriations to be used
inefficiently. GAO will be examining additional DOD business activities
to determine the extent of the problem.

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

 REPORTNUM:  AIMD/NSIAD-97-74
     TITLE:  Navy Ordnance: Analysis of Business Area Price Increases 
             and Financial Losses
      DATE:  03/14/97
   SUBJECT:  Labor costs
             Military cost control
             Overhead costs
             Ammunition
             Revolving funds
             Financial management
             Military appropriations
             Equipment maintenance
             Federal agency reorganization
             Losses
IDENTIFIER:  Defense Business Operations Fund
             Navy Working Capital Fund
             
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Cover
================================================================ COVER


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

GAO/AIMD-97-74

Navy Ordnance

(511357)


Abbreviations
=============================================================== ABBREV

  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

Letter
=============================================================== LETTER


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. 


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



EXECUTIVE SUMMARY
============================================================ Chapter 0


   PURPOSE
---------------------------------------------------------- Chapter 0:1

The Chairman, Subcommittee on Military Readiness, House Committee on
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. 


   BACKGROUND
---------------------------------------------------------- Chapter 0:2

The Navy ordnance business area provides various services, including
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 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. 


   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

The business area's price increased from $50.02 per direct labor hour
in 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. 


   PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4


      FACTORS CONTRIBUTING TO
      PRICE INCREASES
-------------------------------------------------------- Chapter 0:4.1

The Navy ordnance business area's composite sales price\1 increased
from $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

   (See figure in printed
   edition.)

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. 


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


      FACTORS CONTRIBUTING TO
      LOSSES
-------------------------------------------------------- Chapter 0:4.2

The Navy ordnance business area reported losses of about $212 million
for 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
      REQUIRES MORE ACCURATE AND
      CONSISTENT INFORMATION
-------------------------------------------------------- Chapter 0:4.3

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


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

We are making recommendations to the Secretary of Defense and the
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. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6

In its written comments on this report, DOD stated that overall the
report 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. 


INTRODUCTION
============================================================ Chapter 1

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. 


   WHY INDUSTRIAL FUNDS WERE
   ESTABLISHED
---------------------------------------------------------- Chapter 1:1

During the 1940s, the Hoover Commission, while studying abuses in
government operations, found that the military budget and
appropriation 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 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. 


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


   DOD ESTABLISHED DBOF
---------------------------------------------------------- Chapter 1:2

In October 1991, DOD established DBOF, which consolidated the nine
existing industrial and stock funds operated by the military services
and 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 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

   (See figure in printed
   edition.)


   BUSINESS AREAS' BUDGET AND
   PRICE SETTING PROCESS
---------------------------------------------------------- Chapter 1:3

Present DOD policy requires the business areas to establish prices
that allow them to recover from their customers the expected costs,
including any prior years' losses.  The business areas are to
establish prices before 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. 


   NAVY ESTABLISHED THE NAVAL
   ORDNANCE CENTER
---------------------------------------------------------- Chapter 1:4

In October 1993, the Navy reorganized the Navy ordnance business area
and established the Naval Ordnance Center (NOC) in order to address
various ordnance logistics management deficiencies that had been
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 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. 

   Figure 1.2:  Naval Ordnance
   Center Activities

   (See figure in printed
   edition.)

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 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

   (See figure in printed
   edition.)

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 performed by NOC declined from a reported 9.7
million DLHs in fiscal year 1992\4 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)

   (See figure in printed
   edition.)

Source:  Navy Ordnance Business Area. 


--------------------
\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. 

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


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:5

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

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's comments where appropriate.  These comments are
discussed in chapters 3 and 4 and are reprinted in appendix I. 


FACTORS CAUSING PRICES TO INCREASE
============================================================ Chapter 2

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 1994-96
                          Sales Price Increase

                                              Impact on     Percent of
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
----------------------------------------------------------------------

--------------------
\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. 


   CURRENT PRICES MORE ACCURATELY
   REFLECT TOTAL COST OF
   OPERATIONS
---------------------------------------------------------- Chapter 2:1

The Navy ordnance business area has been working to implement DBOF
and is capturing more of the total cost of its operations and
reflecting those costs in the prices charged customers.  As shown in
table 2.1, our 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 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. 


      FISCAL YEAR 1996 PRICES
      INCLUDE NEW COSTS
-------------------------------------------------------- Chapter 2:1.1

About $7.93 of the $15.25 price increase can be attributed to
overhead 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
      CAPACITY NOW INCLUDED IN
      SALES PRICES
-------------------------------------------------------- Chapter 2:1.2

Like many of the business areas, the Navy ordnance business area must
always maintain the capability to meet rapid escalation of demand for
its 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. 

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. 


--------------------
\2 Senate Reports 103-153 and 103-321. 


   PRIOR YEAR LOSSES INCREASE
   SALES PRICES
---------------------------------------------------------- Chapter 2:2

As noted previously, DOD policy requires business areas to adjust
their prices in order to recoup accumulated losses from or return
accumulated 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. 


   DECLINING WORKLOAD CREATES
   PRESSURE TO INCREASE PRICES
---------------------------------------------------------- Chapter 2:3

Since the military forces have been downsizing over the last several
years, the demand for Navy ordnance work has declined.  However, the
business area's overhead costs have not decreased proportionately to
the decline in 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 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 Years 1994 and 1996

                                Budgeted       Budgeted       Budgeted
                                overhead   direct labor       overhead
                                   costs          hours           cost
Fiscal year                   (millions)     (millions)      per DLH\a
-------------------------  -------------  -------------  -------------
1994                                $206            6.9         $29.72
1996                              $200\b            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. 


   HIGHER PRICES RESULT IN
   CUSTOMERS SHIFTING WORK FROM
   NAVY ORDNANCE BUSINESS AREA
---------------------------------------------------------- Chapter 2:4

Due to higher prices, some customers are shifting work from the Navy
ordnance business area to other sources.  Customers are shifting work
from the business area to nonworking capital fund activities that are
not 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 required to charge customers the full cost and
nonworking capital fund 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. 

  -- 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 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. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 2:5

The Navy's implementation of DBOF along with the reorganization to
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. 


FACTORS CONTRIBUTING TO NAVY
ORDNANCE BUSINESS AREA LOSSES
============================================================ Chapter 3

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. 


   PROJECTED OPERATING RESULTS
   HAVE CONSISTENTLY BEEN OVERLY
   OPTIMISTIC
---------------------------------------------------------- Chapter 3:1

The annual DBOF budgets that have been submitted to the Congress have
consistently contained overly optimistic estimates for the Navy
ordnance business area's operating results.  For example, due to the
DOD policy that requires activities to use surcharges to recoup prior
year losses from their customers, the business area was expected to
earn a profit of about $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 Actual Reported
                Operating Results for Fiscal Years 1994-
                                   96

                         (Dollars in millions)

            1994                  1995          1996         Total
----------------------------  ------------  ------------  ------------
                              Budg          Budg          Budg
Budget                Actual    et  Actual    et  Actual    et  Actual
--------------------  ------  ----  ------  ----  ------  ----  ------
($38.1)               ($165.  $89.  ($9.6)  $47.  ($36.7  $98.  ($211.
                          5)     0             7       )     6      8)
----------------------------------------------------------------------
   Figure 3.1:  Estimated
   (Budgeted) vs.  Actual Results

   (See figure in printed
   edition.)

Source:  Navy Ordnance Business Area. 


   OVERHEAD COSTS HAVE BEEN MUCH
   HIGHER-THAN-EXPECTED
---------------------------------------------------------- Chapter 3:2

The primary cause of the business area's losses is that overhead
costs have been much higher than expected.  Specifically, as shown in
table 3.2 and figure 3.2, actual reported overhead costs for fiscal
years 1994 through 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 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 Overhead Costs for
                          Fiscal Years 1994-96

                         (Dollars in millions)

            1994                  1995          1996         Total
----------------------------  ------------  ------------  ------------
                        Actu          Actu          Actu          Actu
Budget                    al  Budget    al  Budget    al  Budget    al
----------------------  ----  ------  ----  ------  ----  ------  ----
$205.5                  $325  $191.2  $272  $287.4  $283  $684.1  $881
                          .5            .2            .9            .6
----------------------------------------------------------------------
   Figure 3.2:  Estimated
   (Budgeted) vs.  Actual Overhead

   (See figure in printed
   edition.)

Source:  Navy Ordnance Business Area. 

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. 


--------------------
\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. 


      BUSINESS AREA ABSORBED
      UNANTICIPATED COSTS
-------------------------------------------------------- Chapter 3:2.1

DOD policy requires business areas to establish sales prices that
allow them 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 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 SAVINGS
      DID NOT MATERIALIZE
-------------------------------------------------------- Chapter 3:2.2

Another major contributor to the business area's higher-than-expected
overhead costs was the failure to achieve cost reductions and
productivity 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 assumptions such as
these had contributed to the losses that the business area had
incurred over the last several years. 


      PROPERLY MATCHING WORKLOAD
      AND WORKFORCE SIZE IS
      DIFFICULT
-------------------------------------------------------- Chapter 3:2.3

A final major cause of the Navy ordnance business area's
higher-than-expected overhead costs is that it has not been able to
quickly 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 intermittent\2 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. 


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


   LOWER-THAN-EXPECTED WORKLOAD
   LEVELS ALSO CONTRIBUTED TO THE
   LOSSES
---------------------------------------------------------- Chapter 3:3

The Navy ordnance business area lost about $39.8 million during
fiscal years 1994 through 1996 because lower-than-expected workload
levels prevented it from generating enough revenue to recover its
overhead costs.  According to Navy ordnance officials, overhead costs
for such things as the salaries of administrative personnel are
generally fixed costs over the short term and are, therefore, usually
incurred regardless of the 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 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

                         Workload (DLHs)
                   ---------------------------
                                                    Budget
                                                  overhead
                                       Shortfa   costs per        Loss
Fiscal year          Budget    Actual       ll         DLH  (millions)
-----------------  --------  --------  -------  ----------  ----------
1994               6,915,20  6,610,58  304,617      $29.72       $ 9.1
                          5         8
1996               5,697,50  5,087,70  609,793      $50.44        30.8
                          0         7
======================================================================
Total              12,612,7  11,698,2  914,410                 $39.8\a
                         05        95
----------------------------------------------------------------------
\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. 


   NAVAL RESERVE UNITS HAVE NOT
   PROVIDED EXPECTED LEVEL OF
   SUPPORT
---------------------------------------------------------- Chapter 3:4

The Navy ordnance business area lost about $13 million during fiscal
years 1994 through 1996 because it had to pay for work that Naval
Reserve units were expected to accomplish but did not.  This work was
to be accomplished as part of a cost savings initiative that was
expected to eventually save about $18 million a year.  The basic
concept was for 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 equivalent of 222 years of support but actually
received only 58 years of support. 

A December 1996 Naval Audit Service report\3 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. 


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


   CONCLUSIONS
---------------------------------------------------------- Chapter 3:5

The Navy ordnance business area has not been able to meet its
financial 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. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 3:6

To ensure that the Navy ordnance business area operates on a
break-even 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. 


   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 3:7

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


EFFECTIVE MANAGEMENT AND OVERSIGHT
REQUIRES ACCURATE AND CONSISTENT
FINANCIAL INFORMATION
============================================================ Chapter 4

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. 


   MORE RELIABLE WORKLOAD
   ESTIMATES ARE NEEDED
---------------------------------------------------------- Chapter 4:1

Over the past several years, the difference between the budgeted DLHs
and the actual direct hours worked has varied widely.  Because prices
charged Navy ordnance customers are based, in part, on the projected
workload to 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 forecast workload and properly size its workforce to
the amount of work it receives, the business area will continue to
incur losses. 


      WORKLOAD VALIDATIONS
      IDENTIFIED MANY PROBLEMS
-------------------------------------------------------- Chapter 4:1.1

The Navy ordnance business area began validating the workload
estimates 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 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
      CONTINUES TO BE A PROBLEM IN
      FISCAL YEAR 1997
-------------------------------------------------------- Chapter 4:1.2

Workload not materializing as planned appears to be a significant
problem again for fiscal year 1997.  While the Navy ordnance business
area 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. 


   UNIFORM PRICE STRUCTURE IS
   COUNTERPRODUCTIVE TO EFFICIENT
   OPERATIONS
---------------------------------------------------------- Chapter 4:2

Prior to the establishment of NOC in fiscal year 1994, each weapons
station charged customers a price for work performed that reflected
the station's estimated costs to do the work, including a surcharge
to recoup losses from or return profits to their customers.  When NOC
was created, the Navy replaced the individual station prices with a
uniform price structure.  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 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 Per Hour to
                 Overall NOC Composite Price for Fiscal
                               Year 1996

                              Individual
                                 weapons
                                 station    NOC overall
                               composite      composite
                               price per      price per
Weapons station                     hour           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
----------------------------------------------------------------------
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. 


   BUDGETING AND ACCOUNTING FOR
   OVERHEAD COSTS ARE NEITHER
   ACCURATE NOR CONSISTENT
---------------------------------------------------------- Chapter 4:3

Knowing the correct cost of operations, including both overhead and
direct costs, is essential for managers to successfully manage
business operations and better control costs.  However, we found that
business area managers do not have such data.  Specifically, as
discussed below, certain budgeting and accounting practices make it
difficult for ordnance managers to (1) ensure that customers only pay
for services they receive or benefit from and (2) assess the business
area's performance and determine whether it is operating efficiently. 


      INACCURATE ALLOCATION OF
      OVERHEAD COSTS BENEFITS
      AMMUNITION STORAGE AND
      DISTRIBUTION CUSTOMERS
-------------------------------------------------------- Chapter 4:3.1

The Navy ordnance business area's overhead costs have not been
properly matched with the appropriate workloads.  Specifically, tens
of millions of dollars in overhead costs related to storing and
distributing ammunition are charged to other workloads, such as
engineering and maintenance.  As 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. 

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
      AND OVERHEAD COSTS IS
      BLURRED
-------------------------------------------------------- Chapter 4:3.2

The Navy ordnance business area is not accurately budgeting and
accounting for costs related to railroad operations.  Naval Sea
Systems 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 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. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 4:4

Reliable and readily accessible financial management information is
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. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 4:5

We recommend that the Secretary of the Navy direct the Navy ordnance
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

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


   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 4:6

DOD agrees with our two recommendations to (1) ensure that workload
used in developing prices are based on more realistic estimates and
(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. 




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================ Chapter 4



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II


   ACCOUNTING AND INFORMATION
   MANAGEMENT DIVISION,
   WASHINGTON, D.C. 
-------------------------------------------------------- Appendix II:1

Gregory E.  Pugnetti, Assistant Director
Ron L.  Tobias, Senior Auditor-In-Charge
William A.  Hill, Senior Auditor
Larry W.  Logsdon, Advisor
Darby W.  Smith, Advisor
Cristina Chaplain, Communications Analyst


   SAN FRANCISCO REGIONAL OFFICE
-------------------------------------------------------- Appendix II:2

Karl J.  Gustafson, Senior Evaluator
Eddie W.  Uyekawa, Senior Evaluator

*** End of document. ***