Air Force Supply Management: Analysis of Activity Group's Financial
Reports, Prices, and Cash Management (Chapter Report, 06/08/98,
GAO/AIMD/NSIAD-98-118).

Pursuant to a congressional request, GAO reviewed the financial
operations of the Department of Defense (DOD) Working Capital Fund,
focusing on the: (1) accuracy and consistency of the Air Force supply
management activity group's (SMAG) accounting and budgetary reports; (2)
group's price-setting process; and (3) Air Force Working Capital Fund's
cash management practices.

GAO noted that: (1) the Air Force has had difficulties producing
reliable financial information on the supply management activity group's
operations, setting prices for inventory the group sells to customers,
and generating sufficient cash to help discontinue the Air Force Working
Capital Fund's practice of advance billing its customers since 1993; (2)
these weaknesses impair the Air Force's ability to: (a) ensure that
customers can purchase inventory items when needed; and (b) achieve the
goals of the working capital funds, which are to focus management
attention on the full costs of carrying out operations and to manage
those costs effectively; (3) at the core of many of the supply
management activity group's financial management weaknesses is its
inability to produce reliable information on its cost of goods sold and
net operating results; (4) this financial information is critical since
the activity group must set prices that reflect the expected costs of
providing inventory items to customers; (5) if these data are
inaccurate, the activity group's prices may not cover its full cost of
operations or generate enough cash to pay its bills, which has been the
case in recent years; (6) until the Air Force can: (a) develop accurate
information on the supply management activity group's net operating
results and cost of goods sold; (b) use this information to develop an
effective price-setting process; and (c) acquire and use management
tools for projecting cash outlays--its customers will remain susceptible
to wide price fluctuations and a corresponding depletion of funds; (7)
further, the Air Force Working Capital Fund will have to continue to
advance bill customers so that it has enough cash to pay its bills; and
(8) finally, senior managers and those responsible for providing
oversight will continue to lack the information they need to make
informed decisions on Air Force supply operations.

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

 REPORTNUM:  AIMD/NSIAD-98-118
     TITLE:  Air Force Supply Management: Analysis of Activity Group's 
             Financial Reports, Prices, and Cash Management
      DATE:  06/08/98
   SUBJECT:  Cash management
             Data integrity
             Military inventories
             Military cost control
             Federal agency accounting systems
             Financial records
             Billing procedures
IDENTIFIER:  Air Force Working Capital Fund
             Defense Business Operations Fund
             DOD Working Capital Fund
             
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Cover
================================================================ COVER


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

June 1998

AIR FORCE SUPPLY MANAGEMENT -
ANALYSIS OF ACTIVITY GROUP'S
FINANCIAL REPORTS, PRICES, AND
CASH MANAGEMENT

GAO/AIMD/NSIAD-98-118

Air Force Supply Management

(511635 and 709293)


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

  AFMC - Air Force Materiel Command
  ALC - Air Logistics Center
  DFAS - Defense Finance and Accounting Service
  DOD - Department of Defense
  FMS - Foreign Military Sales
  GAO - General Accounting Office
  SMAG - Supply Management Activity Group

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


B-278060

June 8, 1998

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

Dear Mr.  Chairman: 

This report, one in a series\1 you requested on the financial
operations of the Department of Defense's (DOD) Working Capital
Funds, addresses the Air Force supply management activity group. 
This supply management activity group supports combat readiness by
procuring critical material and making repair parts available to its
customers such as military units.  The group operates under the
working capital fund concept, where customers are to be charged the
costs of providing goods and services to them.  During fiscal year
1997, the group was responsible for inventory with a reported value
of about $24.5 billion. 

As requested, this report discusses (1) the accuracy and consistency
of the Air Force supply management activity group's accounting and
budgetary reports, (2) the group's price-setting process, and (3) the
Air Force Working Capital Fund's cash management practices. 

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 Air Force; 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, Assistant Director, at (202) 512-6240.  Other major
contributors to this report are listed in appendix II. 

Sincerely yours,

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

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



--------------------
\1 We issued two reports on the Navy Ordnance activity group
(GAO/AIMD/NSIAD-97-74, March 14, 1997, and GAO/AIMD/NSIAD-98-24,
October 15, 1997). 


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


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

The supply management activity group is the Air Force's primary
purchaser of inventory and the largest activity group in the Defense
Working Capital Funds.  In view of the group's significance to the
working capital funds and Air Force readiness, the Chairman,
Subcommittee on Military Readiness, House Committee on National
Security, asked GAO to evaluate (1) the accuracy and consistency of
the Air Force supply management activity group's accounting and
budgetary reports, (2) the group's price-setting process, (3) the Air
Force Working Capital Fund's cash management practices, including the
practice of advance billing customers to maintain an adequate cash
balance, and (4) the effectiveness of the supply management activity
group in providing needed inventory items to customers in a timely
manner.  This report responds to the first three financial issues
discussed above.  GAO plans to issue a separate report on the fourth
issue dealing with the group's effectiveness in meeting customers'
needs. 


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

The Air Force supply management activity group provides about two
million types of inventory items, including weapon system spare
parts, fuels, and medical-dental supplies, to customers which consist
primarily of DOD organizations.\1 DOD reported that the group had
$24.5 billion in inventory at the end of fiscal year 1997 and about
$12 billion in revenue from the sale of goods to its customers during
fiscal year 1997.  The group is part of the Air Force Working Capital
Fund, a revolving fund that relies on sales revenue, rather than
direct congressional appropriations, to finance its operations. 
Working capital funds are to (1) generate sufficient revenues to
cover the full costs of their operations and (2) operate on a
break-even basis over time--that is, not make a profit nor incur a
loss.  It is essential that the working capital funds operate
efficiently since every dollar spent inefficiently results in less
funds available for other defense spending priorities. 

The Air Force supply management activity group generates revenue by
selling customers inventory and billing them at predetermined prices
(standard prices).  Those prices, which typically are to be stable
throughout the fiscal year, consist of two major elements:  (1) the
acquisition or repair cost of the inventory sold plus (2) operational
costs, such as salaries and storage costs.  In developing the prices
for individual inventory items which are to reflect the full cost,
the Air Force adds a surcharge to the acquisition cost or repair cost
of items to recover the operational costs.  Customers primarily use
operations and maintenance appropriations to pay for the inventory
items.  Payments from customers replenish the cash balance in the Air
Force Working Capital Fund, which is used to finance ongoing
operations. 


--------------------
\1 The supply management activity group also sells inventory items to
foreign governments. 


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

The Air Force has had difficulties producing reliable financial
information on the supply management activity group's operations,
setting prices for inventory the group sells to customers, and
generating sufficient cash to help discontinue the Air Force Working
Capital Fund's practice of advance billing its customers since 1993. 
These weaknesses impair the Air Force's ability to (1) ensure that
customers can purchase inventory items when needed and (2) achieve
the goals of the working capital funds, which are to focus management
attention on the full costs of carrying out operations and to manage
those costs effectively. 

At the core of many of the supply management activity group's
financial management weaknesses is its inability to produce reliable
information on its cost of goods sold and net operating results (the
difference between annual revenue and expenses).  This financial
information is critical since the activity group must set prices that
reflect the expected costs of providing inventory items to customers. 
If these data are inaccurate, the activity group's prices may not
cover its full cost of operations or generate enough cash to pay its
bills, which has been the case in recent years.  Until the Air Force
can (1) develop accurate information on the supply management
activity group's net operating results and cost of goods sold, (2)
use this information to develop an effective price-setting process
that enables the supply management activity group to operate on a
break-even basis and helps ensure that customers receive adequate
funding to purchase needed inventory items, and (3) acquire and use
management tools for projecting cash outlays, its customers will
remain susceptible to wide price fluctuations and a corresponding
depletion of funds.  Further, the Air Force Working Capital Fund will
have to continue to advance bill customers so that it has enough cash
to pay its bills.  Finally, senior managers and those responsible for
providing oversight will continue to lack the information they need
to make informed decisions on Air Force supply operations. 


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


      LONG-STANDING FINANCIAL
      REPORTING PROBLEMS CONTINUE
-------------------------------------------------------- Chapter 0:4.1

GAO has previously reported\2 that DOD has had long-standing problems
in preparing accurate financial reports on its working capital fund
operations.  DOD has frequently acknowledged that working capital
funds' financial reports were inaccurate and cited actions being
taken to correct this problem.  GAO found that some of these actions
have not yet been completed, and serious financial reporting problems
still exist.  The Air Force supply management activity group's net
operating result and cost of goods sold information contained in
DOD's monthly accounting reports and Chief Financial Officer reports
sent to the Congress have consistently varied by billions of dollars. 
For example, the fiscal year 1996 net operating results reported in
the monthly accounting report and the Chief Financial Officer report,
which should agree with each other, differed by $4.2 billion. 
Further, the budget justification report reflected a third, different
net operating result, which was not reconciled to the accounting
reports.  As a result, DOD, the Air Force, and the Congress have not
received accurate information on the Air Force supply management
activity group's net operating results--a critical piece of
information since it is one factor used in setting prices to be
charged to customers in subsequent years.  The cost of goods sold
represents the single largest expense to the activity group. 

Congressional defense committees have raised concerns about the
working capital funds' financial and management problems over the
last several years.  To improve the management of the working capital
funds, the National Defense Authorization Act for Fiscal Year 1997
required DOD to develop a corrective action plan by September 30,
1997.  GAO found that the plan DOD developed to address this
requirement does not contain the specific steps that need to be taken
to correct the problems.  DOD officials told GAO that (1) they are
identifying the detailed steps for correcting the problems addressed
in the plan and (2) correcting many of the problems will require
improving the existing accounting and logistical systems or
developing new systems, which will take some time to show results. 


--------------------
\2 Defense Business Operations Fund:  Management Issues Challenge
Fund Implementation (GAO/AIMD-95-79, March 1, 1995); Defense Business
Operations Fund:  Improved Pricing Practices and Financial Reports
Are Needed to Set Accurate Prices (GAO/AIMD-94-132, June 22, 1994);
Financial Management:  Status of the Defense Business Operations Fund
(GAO/AIMD-94-80, March 9, 1994); and Letter to Congressional
Committees on the Defense Business Operations Fund (GAO/AFMD-93-52R,
March 1, 1993). 


      DIFFICULTIES ENCOUNTERED IN
      DEVELOPING PRICES
-------------------------------------------------------- Chapter 0:4.2

Two objectives of the supply management activity group's
price-setting process are to (1) establish prices for individual
inventory items that are to reflect the expected full cost of
providing these items to customers and (2) develop the activity
group's composite, or aggregate, price change that is used in
budgeting so that customers have the funds available to buy needed
inventory items from the activity group.  During the budget process,
the composite price change is approved by the Under Secretary of
Defense (Comptroller). 

GAO found that the Air Force lacks controls to ensure the composite
price change approved by the Under Secretary of Defense (Comptroller)
during the budget process is properly implemented.  For example, the
supply management activity group's fiscal year 1997 prices for
repairable inventory items were reduced by about 18 percent,
effective April 1, 1997, when budget execution data showed that
customers were spending much more than expected for purchases of
inventory.  According to Air Force officials, this problem occurred
because the supply management activity group had to pay more than
budgeted for repairing items, causing prices to the customers to be
higher than those approved during the budget review process.  Air
Force officials told GAO that if they had not lowered prices in April
1997, their customers would have run out of funds before the end of
the fiscal year. 

Further, the Air Force revised its cost allocation procedures at the
beginning of fiscal year 1998 to better match the group's estimated
operational costs with the prices charged for individual inventory
items.  The activity group now estimates the costs associated with
(1) individual supply activities--the five Air Logistics Centers--and
allocates each Center's costs to only those items that the center
manages and (2) procuring inventory items to replace items that can
no longer be repaired and allocates the estimated replacement cost to
the item being replaced.  Prior to fiscal year 1998, all of the
activity group's estimated operating costs were aggregated and then
spread uniformly to all the items that the Air Force manages.  The
new procedure, together with the increased awareness of the need for
reliable financial data, should eventually allow Air Force managers
to better identify inefficient operations and activities and to make
more informed decisions about managing the group's infrastructure
costs. 

However, the Air Force's ability to achieve these benefits is
constrained by a lack of reliable data.  For example, because it
lacks reliable sales revenue and operational cost data for individual
Air Logistics Centers, the Air Force changed the amount of operating
cost allocated to individual inventory items after prices were
established for fiscal year 1998.  This resulted in three different
sets of prices for individual inventory items during fiscal year
1998.  The Air Force's initial allocation of funding has left some
customers with either too much or too little funding for purchasing
needed items.  Although Air Force headquarters can alleviate this
problem by reallocating available funds, it lacks the reliable
historical and budget execution data it needs to do so effectively. 


      AIR FORCE WORKING CAPITAL
      FUND AND SUPPLY MANAGEMENT
      ACTIVITY GROUP CASH
      MANAGEMENT PROBLEMS
-------------------------------------------------------- Chapter 0:4.3

GAO has previously reported that the working capital funds have had a
long-standing cash management problem and have adopted the practice
of advance billing customers.  Since 1993, the funds have advance
billed customers for work not yet performed in order to have enough
cash to pay their bills.  DOD initially expected the funds to
generate sufficient cash to eliminate advance billing in fiscal year
1995.  When this did not occur, DOD called for an end to advance
billing in fiscal year 1996, and again in fiscal year 1997, in its
working capital fund budgets.  The Air Force had steadily reduced its
working capital fund's outstanding advance billing balance from about
$1.3 billion in February 1995 to $77 million in November 1996. 
However, to ensure that the fund's cash balance would remain
positive, the Air Force advance billed customers over $1 billion in
December 1996 and about $700 million in the June/July 1997 time
period.  As of the end of fiscal year 1997, the Air Force Working
Capital Fund had an outstanding advance billing balance of $464
million.  This working capital fund cash balance would have been a
negative $340 million if the Air Force had not advance billed
customers. 

Since the Air Force maintains one cash balance at the overall Air
Force Working Capital Fund level and the supply management activity
group is responsible for more than half of the Fund's cash
collections and disbursements, it is important that the Air Force
supply management activity group properly manage cash.  GAO found
that the activity group did not accurately project cash collections
from foreign military sales.  Specifically, inaccurate projection of
foreign military sales resulted in actual cash collections being
about $429 million less than budgeted from fiscal year 1993 through
fiscal year 1996.  Air Force officials stated that they need better
management tools, such as a cash forecasting model for projecting
cash collections and disbursements.  They also stated that they do
not have the basic information for projecting cash outlays, such as
item managers' projections on when items will be delivered from
contractors and subsequent payment made to the contractors. 

The Air Force recognizes that it has a cash problem and increased its
working capital fund customer prices for fiscal years 1998 and 1999
to generate an additional estimated $275 million.  If these price
increases do not alleviate the cash problem, the Air Force may have
to continue increasing prices to generate cash. 


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

GAO is making recommendations to the Secretary of Defense and the
Secretary of the Air Force for improving the Air Force supply
management activity group's financial reporting, price-setting, and
cash management practices.  These recommendations focus on (1)
developing a plan to improve the accuracy of the group's financial
reports, especially the cost of goods sold and net operating results
figures that are included in the financial reports, (2) developing
procedures to ensure that approved prices are actually implemented
and used to charge customers for inventory purchases, (3) assessing
the impact of price changes on customers to determine whether goods
are acquired by customers when needed and taking funding reallocation
actions, as appropriate, and (4) improving the Air Force's cash
management practices by developing a cash forecasting model that
includes the capabilities to forecast required cash levels,
end-of-period cash positions, and disbursements to be made in future
years. 


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

In its written response to this report, DOD concurred with GAO's
findings and recommendations and identified actions the Department
and the Air Force are taking to correct the identified deficiencies. 
For example, DOD has begun considering ways to improve its method for
calculating inventory valuations as well as to improve financial
statement reporting.  DOD further stated that the actions it is
taking to implement GAO's recommendations should improve the
reliability and accuracy of the Air Force's supply activity group's
operations. 


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

The Air Force supply management activity group (SMAG) helps to
maintain combat readiness and sustainability by supplying the Air
Force with items necessary to support troops, weapon systems,
aircraft, communications systems, and other military equipment.  In
doing so, SMAG is responsible for about two million items, ranging
from weapon system spare parts to fuels, food, medical and dental
supplies and equipment, and uniforms.  SMAG is the largest supply
management activity in Defense--it reported $12 billion in revenue
and $24.5 billion in inventory for fiscal year 1997. 

SMAG operations are financed as part of the Air Force Working Capital
Fund, which was formerly a part of the Defense Business Operations
Fund.  In December 1996, the Under Secretary of Defense (Comptroller)
dissolved the Defense Business Operations Fund and created four
working capital funds\1 to clearly establish the military services'
and DOD components' responsibilities for managing the functional and
financial aspects of their respective activity groups.  The funds are
to operate by charging customers the full costs of goods and services
provided to them as currently defined in the Department of Defense's
(DOD) Financial Management Regulation, Volume 11B, Reimbursable
Operations, Policy and Procedures--Defense Business Operations Fund. 

The primary goal of the current working capital fund financial
structure is to focus the attention of all levels of management on
the full costs of carrying out certain critical DOD business
operations and the management of those costs.  Unlike a private
sector enterprise which has a profit motive, the four working capital
funds are to operate on a break-even basis over time by recovering
the full costs incurred in conducting the business operations. 
Accomplishing this requires DOD managers to become more conscious of
operating costs and make fundamental improvements in how DOD conducts
business since customers have a defined amount of funds to pay for
goods and services.  It is critical for the working capital funds to
operate efficiently since every dollar spent inefficiently is one
less dollar available for other defense spending priorities. 

As figure 1.1 illustrates, SMAG receives orders from customers to
purchase inventory items.  Customers use appropriated funds,
primarily Operation and Maintenance appropriations, to finance these
orders.  SMAG provides the inventory items to customers and bills
customers on the basis of predetermined prices--commonly referred to
as standard prices, which generally are to be in force throughout the
entire fiscal year.  SMAG uses payments from customers to replenish
the inventory sold to customers by (1) buying new inventory items or
(2) ordering repair services of existing inventory from industry and
DOD depot maintenance activities as well as to cover operating costs. 
SMAG procures critical material and makes repair parts available to
its customers through five inventory control points:  Ogden Air
Logistics Center (ALC), Ogden, Utah; Oklahoma City ALC, Oklahoma
City, Oklahoma; Sacramento ALC, Sacramento, California; San Antonio
ALC, San Antonio, Texas; and Warner Robins ALC, Warner Robins,
Georgia.\2 The five ALCs report to the Air Force Materiel Command
(AFMC), located at Dayton, Ohio. 

   Figure 1.1:  Supply Management
   Activity Group Operations

   (See figure in printed
   edition.)

   Source:  Department of the Air
   Force.

   (See figure in printed
   edition.)

SMAG's operations are divided into two main categories:  wholesale
and retail.  Wholesale operations encompass about 200,000 types of
inventory items (generally weapon system related) for which the Air
Force is the inventory control point.  SMAG procures, manages, and
sets the prices that customers will pay for these wholesale items. 
The wholesale prices include SMAG's operational support cost, such as
civilian salaries and accounting costs.  SMAG adds a surcharge to the
acquisition cost or repair cost of the individual inventory items to
recover its operating costs.  SMAG retail inventory operations
encompass items that are managed by the other services, Defense
agencies,\3 or government agencies.  These non-Air Force entities are
the inventory control points for these items and, therefore, set the
prices for these items.  The retail portion of SMAG purchases these
items from the non-Air Force entities and then resells them to
customers. 

Since fiscal year 1991, the composition of the inventory items and
costs managed by SMAG has significantly changed, making it more
complicated for SMAG to manage, budget, and account for inventory. 
Prior to fiscal year 1991, SMAG consisted of the following six
divisions:  (1) systems support, (2) general support, (3) fuels, (4)
medical/dental, (5) commissary, and (6) the Air Force Academy Cadet
Store.  The systems support division--the only wholesale
division--procured consumable items (items that are replaced rather
than repaired) for aircraft, missiles, and their major components. 

Beginning in fiscal year 1991, the Air Force added two new wholesale
divisions to its stock fund operations:  the reparable support and
cost of operations divisions.  The reparable support division
procures depot level repairables and pays for the repair of these
repairable inventory items.  Managing repairable items was a new
function for SMAG,\4 and it complicated the budgeting and accounting
for inventory items since SMAG did not have any experience in setting
prices to recover the cost to repair items.  The cost of operations
division included the overhead costs for the five inventory control
points of the stock fund which also complicated matters for the stock
fund since these costs were not previously captured and included in
the prices charged customers.  The effect of adding the repairable
support and cost of operations divisions to the stock fund is
significant.  For example, in fiscal year 1997, the Air Force
reported wholesale division sales of about $6.8 billion of which only
a reported $500 million pertained to the systems support
division--the only wholesale division that existed prior to fiscal
year 1991. 

Three other changes also impacted SMAG's operations. 

  -- In fiscal year 1992, the commissary division was transferred
     from SMAG to the Defense Commissary Agency.  The Air Force
     budgets show that the commissary division had estimated sales of
     $2.6 billion to $2.8 billion per year in the early 1990s. 

  -- About 475,000 consumable items were transferred from the system
     support division to the Defense Logistics Agency from fiscal
     year 1992 through 1997.  The transfer of these items
     significantly reduced the number of items managed by the systems
     support division to about 125,000 items. 

  -- On October 1, 1997, the Air Force consolidated SMAG's three
     wholesale divisions into one wholesale division called the
     Materiel Support Division.  The Air Force created the Materiel
     Support Division to provide better cost visibility.  Now, the
     estimated costs associated with each ALC are included in the
     prices of inventory items they manage.  Previously, these costs
     were spread across the board to all inventory items. 


--------------------
\1 The four working capital funds are the Army, Navy, Air Force, and
Defense-wide. 

\2 The Air Force is in the process of closing the Sacramento and San
Antonio ALCs based on the 1995 Base Realignment and Closure
recommendations. 

\3 The Defense Logistics Agency manages most consumable items. 

\4 Prior to fiscal year 1991, repairable items were not part of SMAG. 
The Air Force used procurement appropriations to centrally purchase
repairable items and provided these items to customers free of
charge.  When an item needed repair, the customers returned the item
and received a replacement item free of charge. 


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

The objectives of our review were to evaluate the (1) accuracy and
consistency of SMAG's accounting and budgetary reports, (2) SMAG's
price-setting process, and (3) Air Force Working Capital Fund's cash
management practices, including the practice of advance billing
customers. 

To evaluate the accuracy and consistency of SMAG's accounting and
budgetary reports, we (1) obtained and analyzed the Defense Working
Capital Fund Accounting Report (1307), the Air Force Defense Business
Operations Fund Chief Financial Officer Annual Financial Statement,\5
and the Air Force's Working Capital Fund budget justification report
for fiscal years 1992 through 1996,\6 (2) interviewed Air Force and
Defense Finance and Accounting Service (DFAS) officials to determine
why reports covering the same period provided widely different
results, and (3) analyzed the DOD Working Capital Fund report, dated
September 1997, that was prepared in response to the National Defense
Authorization Act for Fiscal Year 1997, to determine the actions DOD
is planning to improve the accuracy of the working capital fund's
accounting report.  We also met with DOD Inspector General and Air
Force Audit Agency officials to discuss the accuracy of SMAG's
financial reports. 

The quantitative financial information used in this report on SMAG's
financial operations was produced from DOD's systems--which have long
been reported to generate unreliable data.  We did not independently
verify this information.  The DOD Inspector General has cited system
deficiencies and internal control weaknesses as major obstacles to
the presentation of financial statements that would fairly present
the Defense Business Operations Fund financial position for fiscal
years 1993 through 1996. 

To evaluate SMAG's price setting-process, we (1) obtained and
analyzed the budget documents used in setting prices, (2) interviewed
Air Force comptroller and program officials at Headquarters and AFMC
to discuss the rationale for the various factors, including cost
reduction goals, used to develop SMAG's prices charged customers, (3)
analyzed documents on the new price-setting procedures and
interviewed Air Force officials to determine if the Air Force
encountered problems in implementing the new procedures, and (4)
analyzed budget documents concerning prices and interviewed Air Force
officials to determine why the Air Force changed the fiscal years
1997 and 1998 prices once they were implemented. 

To evaluate the Air Force's Working Capital Fund's cash management
practices, including its practice of advance billing customers, we
(1) collected and analyzed financial information related to the cash
balances, advance billings, collections, disbursements, accounts
receivable, and accounts payable from fiscal year 1992 through fiscal
year 1997, (2) obtained and analyzed DOD and Air Force guidance on
managing cash, and (3) interviewed officials in the Office of the
Under Secretary of Defense (Comptroller), Air Force Headquarters, and
AFMC concerning the cash management practices and the Air Force's
continual need to advance bill customers to alleviate the cash
shortage problem.  We also analyzed the DOD Working Capital Fund
report, dated September 1997, that was prepared in response to the
National Defense Authorization Act for Fiscal Year 1997, to determine
the actions DOD is planning to improve the working capital fund's
cash management practices.  We did not independently verify the
reported cash information. 

We performed our work at the headquarters, Offices of the Under
Secretary of Defense (Comptroller) and Air Force, Washington, D.C.;
Air Force Materiel Command, Dayton, Ohio; the Sacramento Air
Logistics Center, Sacramento, California; Headquarters, Defense
Finance and Accounting Service, Arlington, Virginia; Defense Finance
and Accounting Service Denver Center, Denver, Colorado; Air Combat
Command, Langley Air Force Base, Virginia; Air Mobility Command,
Scott Air Force Base, Illinois; and Air Force Space Command, Peterson
Air Force Base, Colorado.  Our work was performed from August 1997
through May 1998, in accordance with generally accepted government
auditing standards. 

The Department of Defense provided written comments on a draft of
this report.  We incorporated DOD's comments where appropriate. 
These comments are discussed in chapters 2, 3, and 4 and are
reprinted in appendix I. 


--------------------
\5 In December 1996, DOD dissolved the Defense Business Operations
Fund and created four working capital funds. 

\6 The fiscal year 1996 reports were the most recent reports at the
time of our work. 


LONG-STANDING FINANCIAL REPORTING
PROBLEMS CONTINUE
============================================================ Chapter 2

We have previously reported that DOD has had long-standing problems
in preparing accurate working capital fund financial reports,
particularly with regard to the accuracy of net operating results
(the difference between annual revenue and expenses).  These data are
critical in setting prices and ensuring that the funds break-even
over time.  The problems we identified were attributable to
significant deficiencies in the working capital fund accounting
systems as well as a lack of sound internal controls. 

We found that these financial reporting problems persist in SMAG's
accounting and budgeting reports, where we identified billions of
dollars of unexplained differences in the reported net operating
results each year from fiscal years 1992 through 1996.  Because
SMAG's financial reports cannot be relied upon, DOD cannot be certain
(1) of the actual operating results for SMAG or (2) whether the
prices SMAG charges its customers are reasonable. 

In recognizing the funds' financial reporting problems and other
inefficiencies in fund operations, the National Defense Authorization
Act for Fiscal Year 1997 required DOD to develop an improvement plan
by September 30, 1997.  In response to this requirement, DOD
acknowledged that the working capital funds have financial reporting
problems and arrived at decisions to address them.  It has not yet
though developed a detailed implementation plan that lays out the
specific steps that need to be taken to correct the problems. 


   WORKING CAPITAL FUNDS NEED
   ACCURATE FINANCIAL REPORTS TO
   MANAGE OPERATIONS
---------------------------------------------------------- Chapter 2:1

Having accurate financial reporting information is essential to
monitoring fund operations, preparing budgets, and setting proper
prices.  For example, without accurate financial reports on SMAG, DOD
and Air Force managers cannot effectively

  -- analyze trends, such as annual or monthly increases or decreases
     in billings to and reimbursements from customers to reduce or
     eliminate the need for additional working capital;

  -- perform monthly aging analysis of accounts receivable to
     identify old outstanding transactions; and

  -- measure the progress of execution data against the original
     budget, such as monitoring estimated and actual collection and
     disbursement amounts to assess operational and financial
     problems. 

Volume 1 of the Department of Defense Financial Management Regulation
recognizes that DOD accounting systems should provide critical data
for use in budget formulation and monitoring budget execution.  Thus,
it requires that financial management data be recorded and reported
in the same manner throughout DOD components and that accounting
information be synchronized with budgeting information. 


   PERSISTENT FINANCIAL REPORTING
   PROBLEMS IN THE WORKING CAPITAL
   FUNDS
---------------------------------------------------------- Chapter 2:2

As mentioned earlier, we have previously reported\1 that DOD has had
long-standing problems in preparing accurate working capital fund
financial reports, particularly with regard to the accuracy of the
net operating results.  For example, in March 1993, we reported that
although SMAG's fiscal year-end 1992 financial report--as prepared by
DFAS--showed a loss of $8.6 billion, an Air Force analysis disclosed
a profit of $800 million.  The $9.4 billion difference exceeded
SMAG's total revenue reported by DFAS for that year.  Similarly, in
March 1994, we reported that the Navy supply management activity
group's monthly financial report for May 1993 showed a profit of
$23.1 billion which was over five times greater than the $4.3 billion
in reported revenue for the same month and, therefore, was in error. 
We reported in March 1995, that due to a $6 billion clerical error,
the Army supply management activity group reported an operating loss
of $8.5 billion for fiscal year 1994 on a program that reported
revenue of $7 billion for the same period.  In addition, the DOD
Inspector General has not been able to express an opinion on the
accuracy of the Defense Business Operations Fund\2 financial
statements for fiscal years 1993 through 1996 due to significant
deficiencies in the accounting systems and the lack of sound internal
control structure. 

DOD has frequently acknowledged that the working capital funds'
financial reports are inaccurate--in the Acting Comptroller's
February 2, 1993, letter to the congressional defense committees; in
the Defense Business Operations Fund September 24, 1993, improvement
plan; and in DOD's February 2, 1994, response to our October 1993
letter on the Defense Business Operations Fund improvement plan. 

More recently, DOD reported in its fiscal years 1996 and 1997 Annual
Statement of Assurance as required by the Federal Managers' Financial
Integrity Act that inadequate accounting and reporting for the
working capital funds, including the Air Force SMAG, were major
control deficiencies.  The Air Force also recognized SMAG financial
reporting as a material weakness in its fiscal year 1997 Statement of
Assurance.  In this statement, the Air Force reported weaknesses in
inventory valuation and noted the adverse effect it has on
forecasting budget requirements.  It stated that correcting this
problem will result in more accurate inventory pricing and budgets. 
The Air Force also reported that internal controls were not
sufficient to ensure that SMAG accounts were accurately reflected in
financial statements. 

DOD has stated in the past that it was acting to correct these
financial reporting problems.  For example, in the Defense Business
Operations Fund improvement plan dated September 1993, DOD stated
that the primary causes of the financial reporting problems were (1)
inconsistent or insufficient policy guidance and (2) inadequate
financial systems.  DOD's September 1993 plan identified numerous
actions needed to correct the deficiencies identified with the
guidance and financial systems. 

However, because these long-standing problems continued, the
congressional Defense committees acted to mandate improvements in the
financial operations of the working capital funds.  Specifically, the
National Defense Authorization Act for Fiscal Year 1997 required DOD
to prepare a plan by September 30, 1997, to improve the management
and performance of the working capital funds.  Among other things,
the Act required DOD to address the issue involving financial
reporting requirements. 

In response to the authorization act requirement, DOD developed a
plan to improve the management and performance of its working capital
funds.  In this plan, dated September 1997, DOD stated that the
working capital funds have financial reporting problems and DOD
recognized that (1) differences between the budgeting and accounting
reports for the same information confuses managers and should be
eliminated, (2) large adjustments significantly affecting the
operating results can occur as long as 4 months after the "as of"
date and undermine management's confidence in the reports, (3) a
formal reconciliation of the various reports is not presently
performed, and (4) eliminating the differences--or providing a
reconciliation--would make reports more useful to decisionmakers and
restore creditability and confidence in the reports. 

DOD's plan also identifies decisions made to correct these financial
reporting problems which include (1) developing policies and
procedures for reconciling budgetary and accounting reports, (2)
developing a handbook that identifies the differences between the
various reports to assist managers in monthly report analysis, and
(3) revising the cost of goods sold treatment and presentation in the
1307 accounting report. 

The DOD September 1997 plan does a good job in identifying the
problems hindering accurate financial reporting and the decisions
reached to resolve the problems.  However, DOD does not yet have an
implementation plan that identifies (1) the specific tasks that need
to be accomplished, (2) individual DOD component's responsibilities
when two or more components are involved with correcting the problem,
or (3) milestones that could provide a basis for monitoring progress. 
DFAS officials told us that they are developing the detailed tasks
that need to be performed. 


--------------------
\1 Defense Business Operations Fund:  Management Issues Challenge
Fund Implementation (GAO/AIMD-95-79, March 1, 1995); Defense Business
Operations Fund:  Improved Pricing Practices and Financial Reports
Are Needed to Set Accurate Prices (GAO/AIMD-94-132, June 22, 1994);
Financial Management:  Status of the Defense Business Operations Fund
(GAO/AIMD-94-80, March 9, 1994); and Letter to Congressional
Committees on the Defense Business Operations Fund (GAO/AFMD-93-52R,
March 1, 1993). 

\2 The Defense Business Operations Fund is now called the Army, Navy,
Air Force, and Defense-wide Working Capital Funds. 


   SMAG'S FINANCIAL REPORTS ARE
   UNRELIABLE AND INCONSISTENT
---------------------------------------------------------- Chapter 2:3

Financial reporting weaknesses still persist in SMAG's accounting and
budgeting reports.  Our comparison of SMAG's accounting and budgeting
reports for fiscal years 1992 through 1996 identified billions of
dollars of differences in the reported net operating results and cost
of goods sold--two factors that are integral in developing prices to
be charged customers.  Without reliable financial reports, DOD cannot
be certain if SMAG's prices will recover the costs of providing
inventory to its customers.  Moreover, the Congress, DOD, and the Air
Force will not have the information they need for oversight and
decision-making purposes. 


      SMAG'S ACCOUNTING REPORTS
      AND CHIEF FINANCIAL OFFICER
      REPORTS ARE INCONSISTENT
-------------------------------------------------------- Chapter 2:3.1

We compared SMAG's net operating results reported in its Chief
Financial Officer reports (the working capital fund's annual
financial statement) and in its 1307 accounting reports (the fund's
monthly accounting report which provides data on fund operations,
including revenue earned, expenses incurred, profits, and losses) for
fiscal years 1992 through 1996 and identified annual differences
totaling billions of dollars.  For the 3 most recent fiscal years,
these differences are detailed in table 2.1.  Both of these reports
provide budget execution data on SMAG and, therefore, should provide
the same information. 



                               Table 2.1
                
                 SMAG's Reported Net Operating Results
                   for Fiscal Years 1994 Through 1996

                        ((Dollars in millions))

Fiscal year                     CFO report   1307 report    Difference
----------------------------  ------------  ------------  ------------
1994                             $ (119.4)      $3,355.0      $3,474.4
1995                            (12,873.1)     (4,642.9)       8,230.2
1996                               2,162.6   (2,022.2)\a       4,184.8
----------------------------------------------------------------------
\a This is the original 1307 accounting report issued in November
1996.  This report was revised in April 1997 so that the figures
contained in this report and the CFO report would match. 

As indicated in the above table, for fiscal year 1996, the original
fiscal year-end 1307 accounting report, issued in November 1996,
showed that SMAG had a net operating loss of about $2 billion.  After
this report was issued, DFAS made four revisions in preparing the
SMAG portion of the Chief Financial Officer report, which had a major
impact on SMAG's net operating results.  Specifically, DFAS adjusted
the net operating results to show

  -- a positive $459 million in versions one and two of the Chief
     Financial Officer report,

  -- a negative $11 billion in version three, and

  -- a positive $2.2 billion balance in version four--the final Chief
     Financial Officer report. 

After these changes were made, DFAS revised the original 1307 so that
the amounts in that report would match the amounts in the CFO report. 
The size of these changes is significant, especially considering the
fact that SMAG's total revenue was $12.8 billion, according to the
Chief Financial Officer report. 


      THE AIR FORCE HAS NOT
      RECONCILED THE NET OPERATING
      RESULT DIFFERENCES IN THE
      ACCOUNTING REPORT AND THE
      BUDGET JUSTIFICATION REPORT
-------------------------------------------------------- Chapter 2:3.2

We also compared SMAG's reported net operating results in the 1307
accounting report to the Air Force Working Capital Fund budget
justification report--which provides reported actual and budgetary
data on revenue, expenses, net operating results, and prices and is
also essential to managing SMAG operations.  Again, we identified
significant differences totaling billions of dollars for fiscal years
1992 through 1996.  For example, the 1307 accounting report showed
that SMAG lost about
$2 billion during fiscal year 1996 while the budget report showed
that it lost $99 million. 

Differences between these two reports are expected since not all the
accounts used to determine the net operating results in the 1307
accounting report are used to develop the net operating results in
the budget.  For example, if Air Force disposes of inventory items
and does not plan to replace these items, it does not consider this
an expense for budgeting purposes.  However, for accounting purposes,
this is considered an expense that reduces the net operating results. 
The Department of Defense Financial Management Regulation (DOD
7000.14-R) requires business activities to (1) explain the
differences between the net operating results shown in the 1307
accounting report and those used in the budget formulation of prices
charged customers as shown in the budget, (2) identify and justify
the net operating result amounts in the 1307 accounting report that
DOD components request be excluded from the prices, and (3) obtain
approval from the Office of the Under Secretary of Defense
(Comptroller) for the amounts to be excluded.  The Air Force did not
reconcile the net operating results shown in these two reports as
required because it believed that the 1307 accounting report was
incorrect. 

Given the magnitude of the net operating result differences reported
in the 1307 accounting report, Chief Financial Officer report, and
the budget, it is clear that the figures contained in these reports
cannot be relied upon for oversight and decision-making.  Without
knowing the net operating results, the Air Force cannot determine
whether the prices being charged SMAG's customers will allow it to
recover its costs and operate on a break-even basis.  In some cases,
the prices might have been set too high because of erroneous net
operating result data.  In other cases, prices might have been set
too low to recover the costs of providing goods and services, thereby
resulting in a cash shortage.  (See chapter 3 for a discussion of
SMAG pricing problems and chapter 4 for a discussion of cash
problems.)


      SMAG CANNOT DETERMINE AN
      ACCURATE COST OF GOODS SOLD
      AMOUNT
-------------------------------------------------------- Chapter 2:3.3

A root cause of SMAG's inability to accurately report on its
financial operations is that it cannot determine an accurate cost of
goods sold.  The cost of goods sold is an important factor used in
arriving at the group's annual net operating results (revenue less
expenses, which include the cost of goods sold, equals net operating
results).  Our comparison of SMAG's cost of goods sold reported in
its Chief Financial Officer reports, 1307 accounting reports, and
budget justification reports for fiscal years 1992 through 1996
identified differences totaling billions of dollars.  These
differences are detailed in table 2.2. 



                               Table 2.2
                
                 SMAG's Reported Cost of Goods Sold for
                     Fiscal Years 1992 Through 1996

                        ((Dollars in millions))

                                                                Budget
Fiscal year                     CFO report   1307 report        report
----------------------------  ------------  ------------  ------------
1992                                $8,745        $8,909        $7,719
1993                                 7,743         8,754         7,656
1994                                 9,889         7,476         8,313
1995                                15,901         7,132         8,935
1996                                10,929        10,390         8,204
----------------------------------------------------------------------
Office of the Under Secretary of Defense (Comptroller) and/or DFAS
officials told us that DOD's logistical and accounting systems are
not capable of providing the necessary information to identify the
actual (historical) cost of goods sold amount based on normal
commercial practices such as the first-in, first-out cost or weighted
average cost of the items sold.  Therefore, DOD uses the latest
acquisition cost method to value inventory and arrive at the cost of
goods sold which is permissible under the Statement of Federal
Financial Accounting Standards No.  3, Inventory and Related
Property. 

DOD uses a summary-level formula to adjust the value of inventory
from the standard (selling) price to the latest acquisition cost by
removing surcharges for operating costs from the standard price. 
Once DOD determines the latest acquisition cost, it then uses the
following general formula for computing the cost of goods sold: 

Beginning inventory at beginning-of-the-period latest acquisition
cost\3
Less:  Beginning allowance for unrealized holding gains/losses
Plus:  Purchases of goods for sale
Less:  Disposal or other drawdown of goods other than sale
Equals:  Cost of goods available for sale
Less:  Ending inventory at end-of-the-period latest acquisition cost
Plus:  Ending allowance for unrealized holding gains/losses
Equals:  Cost of goods sold

However, as evidenced by the reported differences shown in table 2.2,
DOD has had problems implementing this formula to compute the cost of
goods sold.  Office of the Under Secretary of Defense (Comptroller)
and DFAS officials also told us that in order to determine the actual
(historical) cost of the goods sold, the method for valuing inventory
must be changed from the current method of using the latest
acquisition cost to valuing inventory based on historical costs.  If
DOD changes its method for valuing inventory, it must ensure that its
method complies with the Statement of Federal Financial Accounting
Standards No.  3. 

These officials further stated that by valuing inventory at
historical cost, DOD would know the cost of each individual item
sold, something it does not know now.  This information could then be
summarized for reporting on the supply management activity groups'
financial operations in DOD's monthly accounting reports.  However,
the officials stated that before inventory could be valued at
historical cost, DOD would have to either (1) modify its existing
logistical and accounting systems or (2) develop new ones.  Either
option would be a long-term effort. 


--------------------
\3 Since the latest acquisition cost method provides that the latest
invoice price (price SMAG paid to acquire the item from a vendor) be
used to value all like inventory items regardless of the amount paid
for the items, the inventory needs to be revalued to reflect
unrealized holding gains and losses to arrive at an approximation of
the historical (actual) value of the inventory.  The amount of
unrealized gain or loss is the difference between the recorded value
of the inventory and the actual cost to acquire the inventory. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 2:4

SMAG's financial reports cannot be relied upon to provide DOD and Air
Force management or the Congress reliable information on SMAG's
results of operations.  DOD has discussed this financial reporting
problem in its September 1997 plan on improving the working capital
funds and has identified several actions to correct the problem. 
However, it has not yet developed a detailed implementation plan to
help ensure that the problems are corrected.  Until SMAG can (1)
determine its cost of goods sold and (2) reconcile the net operating
results reported in the 1307 report to the net operating results
reported for budgeting purposes, SMAG's financial reports will
continue to be questioned and lack credibility, and it will be
extremely difficult, or impossible, to determine if the prices
charged customers reflect what they need to be in order to recover
costs. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 2:5

To ensure that DOD acts to correct SMAG's financial reporting
problems and develop an accurate cost-of-goods sold figure, we
recommend that the Secretary of Defense develop a detailed
implementation plan to ensure that the actions identified by DOD in
September 1997 to correct the financial reporting problems are
carried out promptly.  The plan should (1) identify specific actions
that need to be taken including the modification of existing systems
or development of new systems, (2) establish milestones, (3) clearly
delineate responsibilities for performing the tasks in the plan, and
(4) ensure compliance with accounting standards on accounting for
inventory and related property. 

To help link information contained in the accounting report to budget
formulation, we also recommend that the Secretary of the Air Force
direct a reconciliation of the net operating results in the 1307
accounting report to the reported actual net operating results in the
budget justification report that is used for budgeting purposes. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 2:6

In its written comments, DOD concurred with our recommendation to
develop a detailed implementation plan to ensure that the actions
identified by DOD in September 1997 to correct the financial
reporting problems are carried out in a timely manner.  DOD has
established three working groups that will develop specific
implementation and execution plans and procedures for financial
reporting.  These three groups will meet throughout the summer of
1998 with reports expected later this year. 

DOD also concurred with our recommendation to reconcile the net
operating results in the 1307 accounting report to the reported
actual net operating results in the budget justification report that
is used for budgeting purposes.  DOD stated that additional lines
have been added to the Working Capital Fund 1307 accounting reports
to help explain the net operating differences that are reflected in
the two reports. 


DIFFICULTIES ENCOUNTERED IN
DEVELOPING PRICES
============================================================ Chapter 3

DOD policy requires the military services to develop prices for the
working capital funds and use these prices as a basis for determining
customer funding requirements.  The baseline for this process should
be the cost of buying and/or repairing items that are sold--which is
known as the cost of goods sold.  The Air Force, however, does not
have reasonably reliable estimates of the number and type of items
that SMAG customers will need or the expected cost of buying and/or
repairing these items.  Since it cannot use the cost of goods sold as
the basis for SMAG's prices, the Air Force has had to resort to using
two separate processes to develop prices.  The first process is used
to develop a composite, or aggregate, price change in terms of
percentage from one fiscal year to the next.  This price change is
then used to develop customers funding levels.  The second process is
used to establish prices for individual inventory items that reflect
the expected cost of providing these items to customers. 

Ideally, these two processes would ensure that customers will have
sufficient funds to buy the items they need.  However, this objective
is not always accomplished for the following two reasons.  First,
there are no checks to ensure that the composite price changes
approved by the Under Secretary of Defense (Comptroller) are
implemented.  Second, problems with the implementation of new
procedures for allocating operating cost to individual inventory
items could result in some customers receiving either too much or too
little funding in fiscal year 1998, and have left Air Force officials
without the reliable historical and/or budget execution data they
need to effectively reallocate funds. 


   TWO SEPARATE PROCESSES USED TO
   DEVELOP CUSTOMERS' FUNDING
   LEVELS AND PRICES FOR
   INDIVIDUAL ITEMS
---------------------------------------------------------- Chapter 3:1

The two primary objectives of SMAG's price-setting process are to
ensure that (1) prices charged for individual items reflect the
expected cost of providing these items to customers and (2) SMAG's
composite, or aggregate, price change is identified--so that it can
be properly factored into customer budgets.  Because it lacks
reliable data on SMAG's cost of goods sold (see chapter 2) and
reasonable estimates of customers' needs,\1 the Air Force cannot
accomplish these objectives through the traditional
approach--developing prices for individual items and then applying
these prices to estimates of customer needs as the basis for
determining customer funding requirements.  As a result, it uses a
summary-level analysis to establish a composite price change for SMAG
customers and, in turn, customer funding levels, and then attempts to
establish prices for individual items that are consistent with the
composite price change. 


--------------------
\1 SMAG officials acknowledge that it can provide only "ballpark"
estimates of customer requirements, in part, because customer funding
levels are developed between 9 and 15 months before the start of the
fiscal year when they go into effect. 


      CUSTOMER FUNDING LEVELS ARE
      BASED ON HISTORICAL DATA AND
      EXPECTED CHANGES
-------------------------------------------------------- Chapter 3:1.1

During the annual budget review process, the Air Force develops an
estimate of customer funding requirements that is subsequently
approved by the Office of the Under Secretary of Defense
(Comptroller).  This estimate is based on factors such as (1) what
customers have spent on inventory purchases in the past, (2)
anticipated changes in requirements, such as planned deactivations of
units, and (3) expected changes in SMAG's costs, such as the
anticipated effect of planned cost reduction actions.  For example,
during fiscal years 1997 through 1999, using this estimating process,
SMAG's prices and its customers' funding levels were reduced by about
$950 million to reflect the savings the Air Force expects to achieve
from its Lean Logistics initiative.\2

During the annual budget review process, Air Force headquarters also
develops, and the Office of the Under Secretary of Defense
(Comptroller) approves, a composite, or aggregate, price change that
represents the average percentage price increase or decrease that
SMAG customers will experience during the budget year.  As shown in
table 3.1, from fiscal years 1992 through 1998, SMAG's authorized
composite price change ranged from a 26.7 percent increase to a 26.2
percent decrease. 



                               Table 3.1
                
                   SMAG's Authorized Composite Price
                 Changes for Fiscal Years 1992 Through
                                  1998

                                            Percent of composite price
Fiscal year                                                     change
----------------------------------------  ----------------------------
1992                                                            (26.2)
1993                                                              20.7
1994                                                              26.7
1995                                                             (9.9)
1996                                                            (16.5)
1997                                                             (1.2)
1998                                                              19.3
----------------------------------------------------------------------
Source:  DOD budget documents. 


--------------------
\2 This initiative is expected to reduce the amount of time required
to satisfy customers' requests and, in turn, to reduce the number of
items that SMAG must buy or repair. 


      ACTUAL PRICES ARE BASED ON
      LATEST ACQUISITION COSTS OR
      LATEST REPAIR COSTS PLUS
      SURCHARGES
-------------------------------------------------------- Chapter 3:1.2

To ensure that SMAG and other working capital fund activities operate
on a break-even basis over time, DOD policy requires that prices be
(1) based on expected costs and (2) adjusted to return prior year
profits to customers or recoup prior year losses from them.  It also
requires that the prices be established at the beginning of the
fiscal year and remain constant throughout the year. 

Prices that customers actually pay for SMAG's individual inventory
items are determined by adding a surcharge to each item's latest
acquisition cost or latest repair cost.  Specifically, "standard"
prices are determined by adding surcharges to the latest acquisition
costs, and "exchange" prices are determined by adding surcharges to
the latest repair costs.  SMAG charges exchange prices when customers
turn in broken repairable items and receive serviceable items in
return.  It charges standard prices for all nonrepairable items and
for repairable items if customers do not turn in broken items. 

The surcharges that are added to the price of each inventory item are
expected to cover SMAG's operational costs for such things as
salaries, inventory storage, and accounting and automated data
processing services.  They also cover other factors, such as (1)
reductions to reflect the anticipated effect of cost reduction
initiatives and (2) returning profits or recouping prior year losses. 
Between fiscal years 1994 and 1998, these surcharges ranged from a
low of $1.0 billion to a high of $2.1 billion and accounted for
between 30 and 50 percent of SMAG's expected wholesale revenue. 


   PRICING PROCEDURES DO NOT
   ENSURE THAT APPROVED PRICE
   CHANGES ARE PROPERLY
   IMPLEMENTED
---------------------------------------------------------- Chapter 3:2

It is important that the prices established for individual items be
consistent with the composite price change approved by the Under
Secretary of Defense (Comptroller) and used in budgeting.  If actual
prices are set lower than the approved level, then customers may have
more funds than they need and scarce resources may be wasted. 
Conversely, if actual prices are set higher than the approved level,
then customers may not have enough funds to buy the items they need. 

However, the Air Force does not have effective procedures to ensure
that the actual prices are, in fact, consistent with the composite
price change that has been approved by the Under Secretary of Defense
(Comptroller).  It generally does not know that there is a problem
with SMAG's prices until and unless the problem is reflected in
budget execution data.  For example, SMAG's fiscal year 1997 prices
were reduced by about 18 percent, effective April 1, 1997, when
budget execution data showed that customers were spending much more
than expected for inventory items, and Air Force officials determined
that customers did not have sufficient funds to last the remainder of
the fiscal year. 

According to Air Force headquarters officials, this problem occurred
because (1) SMAG had to pay more than budgeted for the repair of
items and (2) when these higher-than-expected costs were incorporated
into SMAG's prices, it caused SMAG's composite price increase to be
higher than the one approved by the Office of the Under Secretary of
Defense (Comptroller) during the budget review process.  Reducing
SMAG's prices without reducing its cost adversely affected SMAG's net
operating results and the Air Force Working Capital Fund's cash
balance. 

The Air Force has recognized that it needs to take additional steps
in the price-setting process.  Specifically, after the prices for
individual items are established and before the start of the fiscal
year, the Air Force believes, and we agree, that it should (1)
determine if the new prices, when applied to the best available
estimate of customer orders, will result in the approved composite
price change and (2) adjust the prices for individual inventory
items, if necessary.  AFMC officials acknowledged the need for
corrective action such as this and indicated that they plan to take
it. 


   NEW COST ALLOCATION PROCEDURES
   AND DATA PROBLEMS HAVE CREATED
   CUSTOMER BUDGETING PROBLEMS
---------------------------------------------------------- Chapter 3:3

New procedures for allocating SMAG's operational costs to individual
inventory items (calculating surcharges), combined with data
reliability problems, have resulted in fiscal year 1998 price changes
that have varied significantly not only from one inventory item to
the next but also from one month to the next.  As a result, the Air
Force's initial allocation of funding to SMAG customers left some
with either too much or too little funding.  Further, although Air
Force headquarters can and has alleviated this problem by
reallocating available funds, it lacks the reliable historical and
budget execution data it needs in order to properly do so now and in
the future. 


      GOAL OF NEW PROCEDURES IS TO
      MORE ACCURATELY ALLOCATE
      COSTS
-------------------------------------------------------- Chapter 3:3.1

As discussed above, prior to fiscal year 1998, SMAG recouped its
expected operational costs by applying a standard surcharge
percentage to all wholesale items.  The advantage of this approach is
that it does not require reliable data on an individual supply
activity's operational costs or projected revenue--because all
operational costs are aggregated and then allocated uniformly to all
items at all supply activities.  The disadvantage is that, under this
approach, the operations of inefficient supply activities are, in
essence, subsidized by more efficient activities.  This, in turn,
makes it difficult to identify inefficient operations and activities,
and causes many customers to pay either more or less than they should
for their inventory purchases.  For example, if one ALC's overhead
costs were higher than the other four ALCs', some of its overhead
costs would be included in the prices charged by the other four ALCs
even though they may operate more efficiently. 

On October 1, 1997, the Air Force made two major changes in SMAG's
cost allocation procedures in order to better match costs with the
prices customers were being charged.  First, under the new cost
allocation procedures, SMAG will, where possible, identify the
estimated costs associated with individual supply activities--the
five ALCs--and allocate each ALC's costs to only those items that it
manages.  Second, the estimated cost of procuring inventory items to
replace repairable items that can no longer be repaired economically
(condemned items) will be recouped by adding a surcharge to the cost
of the item being replaced rather than by adding a standard surcharge
to all repairable items, which was the previous practice. 

Air Force headquarters officials stated that the implementation of
the new cost allocation procedures has led to increased awareness of
costs and increased emphasis on accurately estimating both costs and
sales revenue.  For example, they told us that because SMAG's
operational costs are now allocated, where possible, directly to the
individual ALCs that incur them, the ALCs are now much more aware of
and concerned about these costs.  Similarly, they noted that, because
the ALCs' overhead cost allocations and surcharge percentages are
based largely on their projected sales revenues, there is also
increased emphasis on accurately projecting individual ALC's sales
revenue. 


      SMAG LACKS DATA NEEDED TO
      EFFECTIVELY IMPLEMENT ITS
      NEW COST ALLOCATION
      PROCEDURES
-------------------------------------------------------- Chapter 3:3.2

To effectively implement the new cost allocation procedures, SMAG
needs reliable sales revenue and operational cost data for individual
ALCs.  However, it has neither--in part because it did not begin
accumulating actual sales data for individual ALCs until fiscal year
1997.  As a result, SMAG's initial fiscal year 1998 prices, which
became effective on October 1, 1997, were based on unreliable sales
and operating cost data and, therefore, had to be revised, effective
November 1.  In addition, because some of the November 1, 1997 price
changes were not processed properly by the ALCs' automated systems,
another price change had to be implemented for many items, effective
December 1, 1997. 

Each of these price changes was based on a reallocation of sales
revenue and/or operational costs among the five ALCs and was
associated with a major change in the size of the surcharges added to
individual items.  For example, the surcharges used to establish
exchange prices for Sacramento ALC-managed items ranged from a low of
about 46.6 percent to a high of 287.1 percent. 

Table 3.2 shows how these changes affected the price of individual
items.  For example, customers paid $8,859 for an alternating
generator on October 1.  On November 1, customers paid $23,391--about
2.6 times as much as the price on October 1.  On December 1, they
paid $16,727. 



                               Table 3.2
                
                   Examples of Fiscal Year 1998 Price
                Changes for Sacramento ALC-Managed Items

                                                  Price
                                    ----------------------------------
                                    Fiscal
                            Type      year  Octobe  November  December
Item description            price     1997  r 1997      1997      1997
--------------------------  ------  ------  ------  --------  --------
Klystron tube               Exchan  $114,3  $147,7  $279,001  $279,001
                             ge         26      50
Traveling wave tube         Exchan       $  $200,1  $200,190  $179,849
                             ge     74,273      90
Alternating generator       Exchan       $       $  $ 23,391  $ 16,727
                             ge      7,307   8,859
Load coil                   Standa       $       $  $ 10,623  $ 11,059
                             rd      5,838   7,104
Extractor tool              Standa   $ 570       $   $ 8,093   $ 8,676
                             rd              5,570
----------------------------------------------------------------------
These large price changes distort SMAG customers' budget execution
data for fiscal year 1998 and make it difficult for the customers and
those providing oversight over their operations to determine if an
appropriate level of funding has been provided. 


      NEW COST ALLOCATION
      PROCEDURES HAVE CREATED
      CUSTOMER BUDGETING PROBLEMS
-------------------------------------------------------- Chapter 3:3.3

Although SMAG's December 1, 1997, price change resulted in surcharges
of at least 25 percent for all items at all ALCs, the surcharges are
especially high for Sacramento ALC-managed items.  This is primarily
because Sacramento, which is scheduled to close in July 2001, has a
much lower sales volume than the other ALCs and therefore, must
spread its operational costs over a smaller base.  As shown in table
3.3, the surcharges added to Sacramento's standard prices (132.3
percent) and exchange prices (176.8 percent) are at least three times
higher than those of the other ALCs. 



                               Table 3.3
                
                 SMAG Surcharges\a for Five ALCs as of
                            December 1, 1997

                        Standard price          Exchange price
ALC                     surcharge               surcharge
----------------------  ----------------------  ----------------------
Oklahoma City           26.5%                   45.0%

Ogden                   36.9%                   45.0%

San Antonio             26.0%                   40.4%

Sacramento              132.3%                  176.8%

Warner Robins           26.1%                   32.4%
----------------------------------------------------------------------
\a Standard surcharges are expressed as a percent of the latest
acquisition cost, while exchange surcharges are expressed as a
percent of the latest repair cost. 

Because the ALCs used a standard surcharge in fiscal year 1997,
Sacramento's substantially higher fiscal year 1998 surcharges will
cause price increases for its items to be much higher than the SMAG
average.  As a result, customers that rely heavily on the Sacramento
ALC for their support, such as those that operate
communications-electronics and space systems, are the ones that are
most likely to have received insufficient funding.  For example, the
Air Force Space Command used more than half of its fiscal year 1998
spares funding during the first quarter of the year, and Space
Command officials believe that their units will be unable to acquire
the parts they need unless Air Force headquarters provides additional
funds or they can transfer funds from another program. 

Customers that purchase inventory from the other ALCs also expressed
concern.  For example, officials of the Air Combat Command--which
purchases inventory items from all the ALCs--stated that the
implementation of the new cost allocation procedures have caused them
"tremendous concern." They acknowledged that the numerous pricing
changes that occurred during fiscal year 1998 make it virtually
impossible for them to determine whether they will have sufficient
funding to cover their needs during fiscal year 1998.  However, their
analysis shows that they expect to experience funding shortages in
most of their major weapons systems in fiscal year 1998 if additional
funds are not provided. 

Because (1) SMAG's new procedures for allocating operating cost to
individual inventory items significantly impacted the fiscal year
1998 prices charged customers for individual items and (2) the
overall impact varied significantly from one customer to the next,
the Air Force does not have historical data on the amount of money
needed by individual customers to purchase inventory.  Air Force
budget officials told us that it would take at least 1 to 2 years,
perhaps even more, of actual experience to have sufficient data to
reliably estimate individual customer needs.  As a result, although
the Air Force has already adjusted customer funding levels once,
these officials acknowledged that they will have to continue to
monitor budget execution data and to make further adjustments if
necessary. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 3:4

To develop prices that will enable SMAG to operate on a break-even
basis, the Air Force needs reliable information on (1) SMAG's
expected cost of goods sold and on (2) the expected sales revenue and
operational costs of the individual ALCs.  However, the Air Force
does not have this reliable information.  It also does not have
adequate procedures to ensure that customers receive sufficient funds
to purchase required inventory items and, as a result, had to reduce
SMAG's prices half way through fiscal year 1997 so that customers
would not run out of money.  Compounding this problem are the new
cost allocation procedures and the implementation of those procedures
which resulted in three different sets of prices so far during fiscal
year 1998.  This has caused substantial price fluctuations during
fiscal year 1998 that may cause customers to either purchase fewer
inventory items than they planned or transfer funds from other
accounts. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 3:5

As recommended in the previous chapter, the Air Force needs to
develop an effective process for determining the cost of goods sold. 
In addition, we recommend that the Secretary of the Air Force

  -- assess the impact of price changes to determine whether
     customers can acquire the goods they need in fiscal year 1998
     and take funding reallocation actions, as appropriate, to meet
     the highest priority needs; and

  -- direct the AFMC Commander to develop and implement procedures to
     ensure that the prices that are established for individual
     inventory items are consistent with the composite prices
     developed and approved by the Office of the Under Secretary of
     Defense (Comptroller) during the budget process. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 3:6

In commenting on this report, DOD concurred with our recommendation
to assess the impact of price changes to determine whether customers
can acquire the goods they need in fiscal year 1998 and take funding
reallocation actions as appropriate.  The Air Force has already begun
the process of reallocating resources to customers to ensure program
integrity (vital functions can be performed).  DOD also concurred
with our recommendation to develop and implement procedures to ensure
that the prices that are established for individual inventory items
are consistent with the composite prices developed and approved by
the Office of the Under Secretary of Defense (Comptroller). 


AIR FORCE WORKING CAPITAL FUND AND
SMAG CASH MANAGEMENT PROBLEMS
============================================================ Chapter 4

The Air Force maintains one cash balance at the overall Air Force
Working Capital Fund level and manages the fund's cash at that level. 
To ensure that the fund maintains an adequate level of cash to pay
its bills, it is essential that managers (1) accurately project cash
collections and disbursements and (2) actively monitor the fund's
cash position by performing such analyses as comparing budget
estimates for collections and disbursements to actual collections and
disbursements and determining the reasons for the variances.  DOD
policy requires that if the level of cash becomes low and there is a
possibility of incurring an Antideficiency Act\1 violation, immediate
actions be taken to resolve the cash shortage by advance billing
customers for work not yet performed. 

Since June 1993, the Army, Navy, and Air Force Working Capital Funds,
have experienced cash shortages and have advance billed customers for
work not yet performed to ensure that sufficient funds were available
to meet day-to-day operating expenses.  DOD initially expected the
working capital funds to eliminate advance billing in fiscal year
1995.  However, the Air Force Working Capital Fund has not achieved
this goal and has continued the practice of advance billing
customers. 

Since SMAG is the largest activity group in the Air Force Working
Capital Fund, it is critical that SMAG properly manage its
collections and disbursements.  However, we found that SMAG did not
accurately project cash (1) collections from sales and (2)
disbursements for inventory items purchased from vendors.  Further,
SMAG was not adequately monitoring account receivable balances and
outlay rates, which would have enabled it to identify the problem of
inaccurately projecting collections and disbursements so that
corrective actions could be taken to resolve the problem. 


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


   THE IMPORTANCE OF CASH FOR
   WORKING CAPITAL FUNDS
---------------------------------------------------------- Chapter 4:1

Cash generated from the sale of goods and services is the primary
means by which the working capital funds activities pay their bills. 
The position where the cash balances start each year depends on the
outcome of many decisions made during the budget process with regard
to (1) projecting the volume of inventory items that will be sold,
(2) estimating costs, and (3) setting prices to recover the estimated
full cost of the goods and services.  During the execution of the
budget, the working capital funds operate much like a checking
account:  collections increase the fund's cash balance, and
disbursements (such as salaries and purchases of inventory) reduce
the cash balance.  To the extent that the decisions, such as cost
reduction initiatives, made during the budget process are reasonably
accurate, the funds' cash balances should fall between the minimum
and maximum amount required by DOD.  However, if the decisions are
not accurate, the funds could have too much or not enough cash. 

According to DOD's Financial Management Regulation, Volume 11B, the
working capital funds are to maintain the minimum cash balance
necessary to meet both operational requirements and to meet
disbursement requirements in support of the capital asset program. 
In essence, the funds are to maintain a minimum cash balance which,
at the same time, is sufficient to cover expenses, such as paying
employees for repairing aircraft and vendors for inventory items. 
DOD's policy further requires the funds to maintain cash levels to
cover 7 to 10 days of operational costs and 4 to 6 months of capital
asset disbursements.  To comply with DOD's policy, the Air Force
Working Capital Fund should maintain a cash balance between about
$465 million and $670 million.  If the Air Force Working Capital
Fund's level of cash drops below the minimum required balance and
there is a possibility of incurring an Antideficiency Act violation,
actions will be taken to resolve the cash shortage by advance billing
customers. 

Within the working capital fund there are three major activity
groups--depot maintenance, supply management, and information
services--whose operations significantly impact the fund's cash
balance.\2 Of these activity groups, SMAG is the largest with 65
percent, or about $8.8 billion in reported disbursements out of the
total $13.5 billion in reported disbursement made by the Air Force
Working Capital Fund in fiscal year 1997. 


--------------------
\2 Beginning in fiscal year 1998, the United States Transportation
Command's transportation activity group was transferred from the
Defense Working Capital Fund to the Air Force Working Capital Fund. 


   AIR FORCE WORKING CAPITAL FUND
   IS STILL ADVANCE BILLING
   CUSTOMERS
---------------------------------------------------------- Chapter 4:2

We have previously reported\3 that the Defense Working Capital Funds
have had a long-standing cash management problem including the
practice of advance billing customers.  Since 1993, the working
capital funds have advance billed customers because they have not
been able to generate enough cash to pay their bills.  When the
responsibility for managing cash was returned to the military
services and DOD components in February 1995,\4 the Air Force (as
well as the Army and Navy) continued to advance bill customers so
that its cash portion of the Defense Business Operations Fund would
not have a negative balance. 

According to DOD budget documents, DOD anticipated that the working
capital funds, including the Air Force Working Capital Fund, would be
able to generate enough cash to eliminate advance billing in fiscal
year 1995.  This was to be achieved by (1) not replacing sold
inventory on a one-for-one basis, (2) reducing costs, and (3)
increasing prices for various reasons, such as to recoup prior year
losses.  When the fund failed to generate this cash, subsequent DOD
budgets provided for an end to advance billing in fiscal year 1996,
and again in fiscal year 1997.  We found, however, that the Air Force
Working Capital Fund did not achieve DOD's goal of eliminating the
routine practice of advance billing customers. 

The Air Force steadily reduced the Working Capital Fund's outstanding
advance billing balance from about $1.3 billion in February 1995 to
$77 million in November 1996.  At the same time, the Fund's cash
balance declined from $1.1 billion to $90 million.  To ensure that
its cash balance would remain positive, the Air Force Working Capital
Fund advance billed customers over $1 billion in December 1996 and
about $700 million in the June/July 1997 period.  As of fiscal year
end 1997, the Air Force Working Capital Fund's reported outstanding
advance billing balance was $464 million.  Air Force officials told
us that they now plan to eliminate the outstanding advance billing
balance by the end of fiscal year 1999. 

The following figure shows the (1) reported cash balance for the Air
Force Working Capital Fund and (2) cash balance if the Air Force
Working Capital Fund had not advance billed its customers from
February 1995 through September 1997. 

   Figure 4.1:  Air Force Working
   Capital Fund Reported Cash
   Balance (Dollars in millions)

   (See figure in printed
   edition.)

Source:  DOD.  We did not independently verify this information. 

The Air Force recognizes that it has a cash shortage problem and
added surcharges to generate cash totaling (1) $200 million to SMAG's
fiscal years 1998 and 1999 customers' prices and (2) $75 million to
the Air Force Depot Maintenance Activity Group's fiscal years 1998
and 1999 prices.  If these cash surcharges do not alleviate the
problem, the Air Force may have to continue adding a surcharge to the
prices to generate cash. 

Further, to improve cash management in the Air Force Working Capital
Fund, the Air Force held a meeting in February 1998.  Attending the
meeting were officials from the Office of the Secretary of the Air
Force, AFMC, DFAS, and various ALCs.  The Air Force developed
specific action items for the Depot Maintenance, Information
Services, and Supply Management Activity Groups.  According to Air
Force officials, accounting system enhancements should result in
better forecasting which will help the Air Force reduce the need for
additional cash surcharges and advance billings.  A follow-up meeting
to discuss progress is scheduled for November 1998. 


--------------------
\3 Defense Working Capital Funds:  DOD Faces Continued Challenges in
Eliminating Advance Billing GAO/T-AIMD/NSIAD-97-221, July 22, 1997;
Defense Business Operations Fund:  DOD is Experiencing Difficulty in
Managing the Fund's Cash (GAO/AIMD-96-54, April 10, 1996; Defense
Business Operations Fund:  Management Issues Challenge Fund
Implementation (GAO/AIMD-95-79, March 1, 1995); and Financial
Management:  Status of the Defense Business Operations Fund
(GAO/AIMD-94-80, March 9, 1994). 

\4 When the Defense Business Operations Fund was established, the
responsibility for managing cash was placed under the Office of the
Secretary of Defense (Comptroller) level.  On February 1, 1995, cash
management and the related Antideficiency Act responsibilities were
returned to the military services and DOD component level. 


   SMAG'S CASH COLLECTION AND
   DISBURSEMENT PROJECTIONS NOT
   ACCURATE
---------------------------------------------------------- Chapter 4:3

To facilitate the cash management process, DOD policy requires that
the working capital funds develop cash plans which include estimated
collection and disbursement data.  Being able to accurately project
collections and disbursements is critical to the working capital
funds' ability to maintain an adequate level of cash to meet
operational and capital requirements.  DOD's cash management policy
further requires that projected collections and disbursements be
monitored during execution in order to assess operational and
financial problems and take the necessary actions to correct the
problems.  However, we found that SMAG did not accurately project
cash (1) collections from foreign military sales (FMS) and (2)
disbursements to be made to vendors for inventory items.  In
addition, SMAG managers did not adequately monitor account balance
data on FMS collections and vendor disbursements. 

Our analysis of SMAG's cash plans and reports show that SMAG made a
reported $237.3 million in cash from fiscal year 1992 through fiscal
year 1997.  Our analysis also shows that SMAG made $683.3 million
less than projected in fiscal years 1996 and 1997.  This is of
particular concern since SMAG disbursed more money than it collected
at the same time the Air Force Working Capital Fund was experiencing
a cash shortage problem and was advance billing customers. 


      ESTIMATED CASH FROM FOREIGN
      MILITARY SALES OVERSTATED
-------------------------------------------------------- Chapter 4:3.1

From fiscal year 1993 through fiscal year 1996, AFMC did not
accurately project cash collections from FMS.  AFMC erroneously
estimated FMS revenue based on charging FMS customers the standard
price (acquisition cost of the item plus surcharges) for depot level
repairable inventory items rather than the exchange price (repair
price of the item plus surcharges) that FMS customers actually paid. 
According to Air Force officials, AFMC budgeted FMS revenue and
collections based on the standard price because it assumed that FMS
customers would not be turning in broken inventory items (referred to
as carcasses) in exchange for good, "useable" items.  However, FMS
customers turned in the carcasses.  As a result, actual cash
collections were about $429 million less than budgeted from fiscal
year 1993 through fiscal year 1996. 

The difference between the standard price and exchange price that the
FMS customer paid was recorded in a receivable account called "other
assets accounts receivable--deliveries suspense." As shown below, the
amount steadily grew from fiscal year 1993 through fiscal year 1996. 



                               Table 4.1
                
                Dollar Amount Reported in Account Called
                   Other Asset Accounts Receivable--
                          Deliveries Suspense

                        ((Dollars in millions))

Fiscal year                                                     Amount
----------------------------------------  ----------------------------
1993                                                            $208.2
1994                                                             298.0
1995                                                             527.1
1996                                                             776.8
----------------------------------------------------------------------
Source:  SMAG general ledger.  We did not independently verify this
information. 

Because AFMC personnel were not adequately monitoring account balance
information, they did not realize that FMS customers were turning in
broken items until SMAG started to experience cash problems in early
fiscal year 1996.  This was soon after the Air Force received cash
management responsibilities for the working capital fund.  Until that
time, AFMC managers were not monitoring the account's balances
because, from an overall cash position, there were no adverse issues
regarding SMAG's cash.  AFMC has begun to resolve this problem. 
Beginning in fiscal year 1997, revenue from FMS customers was
budgeted at the exchange price. 


      CASH OUTLAY RATES NOT
      ACCURATELY PROJECTED
-------------------------------------------------------- Chapter 4:3.2

From a cash management standpoint, when SMAG orders inventory items
from vendors, it is critical that the Air Force accurately project
the timing of delivery since SMAG pays the vendors based on the
delivery of the inventory items.  The time period used for projecting
outlays depends on the type of inventory items being purchased and
can cover several years starting from the time the items are ordered
from vendors.  AFMC officials assumed that vendor deliveries, and
thus cash outlays, would be greater in the earlier years of the
delivery period and less in the later years.  Accordingly, AFMC
projected its cash outlays to fit this delivery pattern. 

However, Air Force officials stated that AFMC's projected outlays
have not materialized as expected.  Cash outlays in the early years
were significantly less than expected, while outlays in the later
years were more than expected.  According to Air Force supply
management officials, until recently, outlay rates for the Reparable
Support Division inventory buys were not being updated each year to
better reflect vendor delivery patterns.  The following table
illustrates the shift in projected outlay rates over a 5-year outlay
period.  It also shows the (1) outlay rates that have been used over
the past several years and (2) revised outlay rates--based on the Air
Force's analysis of current outlay pattern--used in developing the
Air Force's fiscal year 1999 budget estimate submission for SMAG. 



                               Table 4.2
                
                Reparable Support Division Original and
                     Revised Projected Outlay Rates

                              Original         Revised      Percentage
                             projected       projected     change from
                          outlay rates    outlay rates     original to
Year of outlay               (percent)       (percent)         revised
----------------------  --------------  --------------  --------------
1st year                           7.8             2.9          (62.8)
2nd year                          24.9            17.0          (31.7)
3rd year                          37.2            32.6          (12.4)
4th year                          17.8            23.8            33.7
5th year                          12.3            23.7            92.7
----------------------------------------------------------------------
Source:  Air Force projected outlay rate schedules. 

AFMC managers did not realize that there was a problem with projected
cash outlays until SMAG started to experience cash problems in early
fiscal year 1996.  According to AFMC officials, outlay rates were not
monitored because there were no adverse issues regarding SMAG's cash. 

AFMC officials told us that they do not have the basic information
for projecting cash outlays, such as item managers' delivery
projections or good, historical data by fiscal year on vendor
contracts.  DOD's September 1997 report\5 also acknowledged that
managers do not have the necessary information nor an automated cash
model to assist them in predicting required cash levels, forecasting
cash positions, or for predicting end-of-period cash positions on a
weekly, monthly, or annual basis. 

AFMC officials acknowledged that they need better management tools
for projecting cash outlays for all types of SMAG outlays.  They
noted that projecting outlay rates is relatively easy for obligations
and disbursements that occur within the same year (such as paying
salaries or accounting services provided by the DFAS).  However, this
process becomes much more complicated when it comes to disbursements
that occur several years after the obligation (such as purchases of
repairable inventory items from vendors), and thus there is a
critical need for better information and tools that can guide fund
managers.  Recognizing this, AFMC contracted with a major public
accounting firm to develop a cash forecasting model. 


--------------------
\5 The National Defense Authorization Act for Fiscal Year 1997
required DOD to prepare a report on improving the management and
performance of the working capital funds. 


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

The Air Force Working Capital Fund depends on its activity groups to
effectively manage their cash in order for the fund to have enough
cash to pay for day-to-day operating expenses.  However, the activity
groups have not generated sufficient cash to eliminate the practice
of advance billing customers.  With regard to SMAG, this activity
group has made less cash than estimated from fiscal year 1993 through
fiscal year 1997.  This problem will undoubtedly persist until SMAG
(1) develops and uses management tools, such as cash forecasting
models to project the amount of collections to be received and
disbursements to be made in future years and (2) emphasizes the need
to monitor account balances and takes steps needed to identify and
correct the problems. 


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

We recommend that the Secretary of the Air Force direct the
Commander, Air Force Materiel Command to

  -- ensure that the development of the cash forecasting model
     includes the capabilities to forecast (1) required cash level,
     (2) end-of-period cash positions on a weekly, monthly, or annual
     basis, and (3) disbursements to be made in future years based on
     when vendors are scheduled to deliver items to SMAG and the
     prices charged by the vendors, and (4) receipts based on SMAG's
     sales; and

  -- monitor accounts receivable balances and cash outlay rates to
     identify anomalies and their causes so that corrective actions
     can be taken. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 4:6

In its comments, DOD concurred with our recommendation to ensure that
the development of the cash forecasting model includes the
capabilities to forecast (1) required cash levels, (2) cash balances,
(3) disbursements, and (4) receipts based on sales.  DOD also
concurred with our recommendation to monitor accounts receivable
balances and cash outlay rates to identify anomalies and their causes
so that corrective actions can be taken. 




(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.)


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

ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION, WASHINGTON,
D.C. 

Gregory E.  Pugnetti, Assistant Director
William A.  Hill, Auditor-In-Charge
Ron L.  Tobias, Senior Auditor
Cristina Chaplain, Communications Analyst

SAN FRANCISCO REGIONAL OFFICE

Karl J.  Gustafson, Senior Evaluator
Eddie W.  Uyekawa, Senior Evaluator
Christine D.  Frye, Senior Evaluator


*** End of document. ***