Defense Acquisitions: Prices of Navy Aviation Spare Parts Have Increased
(Letter Report, 11/06/2000, GAO/GAO-01-23).

For some time, there has been concern over the increases in the prices
of weapon systems spare parts and the adverse impact higher prices have
had on the readiness of the military. Prices for aviation spare parts
managed by the Navy have increased at an annual rate of 12 percent from
1994 to 1999. Several factors have contributed to price increases.
First, the cost of repairing an item has generally gone up over time.
Second, the surcharge that is charged to customers has also increased
over time. The Navy has tried to alleviate customer concerns about high
surcharge rates by moving certain overhead costs from the surcharge to
repair costs. But, this approach simply moved the overhead costs instead
of reducing them. Still, the Navy does understand the need to control
spare parts prices and plans to further investigate the underlying
causes of the increases.

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

 REPORTNUM:  GAO-01-23
     TITLE:  Defense Acquisitions: Prices of Navy Aviation Spare Parts
	     Have Increased
      DATE:  11/06/2000
   SUBJECT:  Military cost control
	     Military procurement
	     Spare parts
	     Prices and pricing
	     Military aircraft
	     Aircraft components
	     Equipment repairs
IDENTIFIER:  Navy Working Capital Fund
	     Hornet Aircraft
	     Harrier Aircraft
	     Sea Stallion Helicopter
	     CH-53 Helicopter
	     F/A-18 Aircraft
	     AV-8 Aircraft

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Testimony.                                               **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
GAO-01-23
A

Report to the Chairman and Ranking Minority Member, Subcommittee on
Readiness and Management Support, Committee on Armed Services, U. S. Senate

November 2000 DEFENSE ACQUISITIONS

Prices of Navy Aviation Spare Parts Have Increased

GAO- 01- 23

Letter 3 Appendixes Appendix I: Scope and Methodology 24

Appendix II: Budgeting and Price- setting Process for Fiscal Year 2000 29

Appendix III: Federal Supply Groups 30 Appendix IV: Repair Cost Change
Distribution 31 Appendix V: Comments From the Department of Defense 32
Appendix VI: GAO Contact and Staff Acknowledgments 36

Lett er

November 6, 2000 The Honorable James M. Inhofe Chairman The Honorable
Charles S. Robb Ranking Minority Member Subcommittee on Readiness and
Management Support Committee on Armed Services United States Senate

This is the third in a series of reports responding to your request that we
review allegations of significant price increases in Department of Defense
(DOD) weapon system spare parts. 1 In particular, some military services
have raised concerns about increases in the prices of spare parts and the
adverse impact escalating prices have had on the readiness of military
forces. In response to these concerns, you requested that we examine trends
in the prices of aviation parts managed by the Navy to (1) determine whether
prices were increasing over time and (2) identify the reasons for the price
increases. In addition, we examined the effect such price changes were
having on customers.

This report focuses specifically on “reparable” spare parts the
Navy and the Marine Corps use to maintain their aircraft and helicopters. 2
These parts are aircraft components that can be economically repaired when
they fail to perform properly. Spare parts are repaired at either military
depots or contractor facilities. Over 90 percent of the time when
requisitioning parts, customers turn in an item that is broken, but that can
be repaired, to the defense logistics system. In 1999, customers spent about
$1.7 billion on these types of requisitions.

Navy spare parts are managed under the Navy Working Capital Fund. This is a
revolving fund that relies on revenues generated from parts and services
sold to customers to finance subsequent operations. It is expected to
generate sufficient revenue to cover the full costs of operations and
operate on a break- even basis over time- that is, not to make a profit or

1 Earlier this year, we issued reports entitled Defense Acquisitions: Prices
of Marine Corps Spare Parts Have Increased( GAO/ NSIAD- 00- 123, July 31,
2000) and Defense Acquisitions: Price Trends for Defense Logistics Agency's
Weapon System Parts( GAO- 01- 22, Nov. 3, 2000). 2 The Marine Corps'
aviation spare parts are managed by the Navy.

incur a loss. Customers order parts from the Navy's supply system and pay
the working capital fund from their appropriations. The Navy establishes
spare parts' prices each fiscal year by either increasing or decreasing them
so that they are in line with the customers' aggregate budgeted amounts.
This concept, in theory, ensures that customers, in the aggregate, have
sufficient funds budgeted to buy their anticipated requirements of spare
parts.

The process for setting prices for parts begins 2 years before the fiscal
year in which prices take effect. Prices are developed to recover estimated
costs for storage, distribution, and other overhead costs incurred in the
delivery of spare parts to customers. To recoup these costs, the Navy adds a
surcharge rate to the latest repair cost of the parts to derive the
customer's price. 3 As part of this process, the Navy also sets an annual
price change rate, that is, an overall percent change in prices that
customers can expect to pay in the upcoming fiscal year. This rate drives
customers' funding, with the goal of ensuring that customers' budgets will
be sufficient to cover the cost of the parts they expect to buy.

We analyzed price trends for about 60,000 of the 70,000 spare parts managed
by the Navy from fiscal year 1994 through 1999. We also analyzed trends for
(1) parts that were sold to customers at any point during the analysis
period (about 20,000 items); (2) parts in frequent demand, that is, those
that experienced sales in each of the analysis years (about 5, 000 items);
and (3) parts unique to select weapon systems. To perform these analyses, we
calculated year- to- year percent changes in customer prices as well as the
annual change in surcharge rates and repair costs. We also looked at the
price change distributions from year to year. We took several steps to
address data quality; however, we did not validate or verify the pricing
data provided by the Naval Inventory Control Point. 4 Appendix I contains
detailed information on our scope and methodology.

3 This price is referred to as the net price. The Navy charges customers a
higher price, referred to as a standard price, when a broken part is not
turned in or when the customer procures new parts for initial provisioning.
This report focuses on net price trends. “Repair cost” refers to
the price the Navy pays a depot or commercial contractor to repair spare
parts.

4 We recently testified on long- standing problems with DOD's ability to
accumulate and report on the value of its inventories. Department of
Defense: Progress in Financial Management Reform( GAO/ T- AIMD/ NSIAD- 00-
163, May 9, 2000).

Results in Brief Prices for all Navy- managed parts increased at an average
annual rate of 12 percent from 1994 to 1999. However, prices for parts with
high sales

volume increased substantially more, at an average annual rate of 27
percent. In addition, prices for parts unique to three weapon systems- the
CH- 53 Sea Stallion transport helicopter, the F/ A- 18 Hornet fighter and
attack aircraft, and the AV- 8 Harrier attack aircraft- also increased more
significantly than the overall average. Moreover, from year- to- year, there
were very strong fluctuations in prices, indicating substantial price
instability.

Several factors have contributed to price increases. First, the cost of
repairing an item has generally increased over time. Second, the surcharge
that is charged to customers also has increased over time. The surcharge has
also fluctuated dramatically from year to year, driving the instability in
the prices charged to customers. Over 70 percent of the price changes
(increases and decreases) from fiscal year 1994 through 1999 can be
accounted for by surcharge fluctuations. Among other factors, these
fluctuations were caused by DOD's and the Navy's attempt to strengthen the
financial viability of the working capital fund, make up for past deficits
and surpluses, and account for savings from efficiency improvements.

The Navy has sought to alleviate customer concerns about high surcharge
rates by moving certain overhead costs from the surcharge to repair costs.
However, this approach merely reallocated the overhead costs, rather than
reducing them. Further, the Navy has not allocated condemnation costs- that
is, the cost to replace items that can no longer be repaired- to the
specific items incurring the costs. Spreading these costs among all items
may hinder managers' incentives to reduce costs.

Lastly, we found that problems in the price- setting process could cause
problems with customer funding. Specifically, the projected price changes
used to set customer budgets have fallen short of actual price changes. With
sales prices based on assumptions that are made as long as 2 years before
the prices go into effect, some variance between expected and actual prices
is inevitable. Navy officials attributed mismatches between actual needs and
forecasted requirements to unanticipated developments that occur after the
projected overall price change was established, such as unexpected delays in
developing a new weapon system and the availability of new, but costlier,
material for parts. As a result of these discrepancies, the Navy has found
itself in situations where it has had to seek supplemental appropriations
and delay procurements of needed parts.

The Navy has recognized the need to control spare part prices in order to
enhance readiness and plans to further investigate the underlying causes of
the increases. The Navy plans to (1) identify specific reasons for increases
in repair costs (such as labor or material cost increases and differences
with commercial repair costs); (2) examine whether certain weapon systems
are driving repair cost changes at the aggregate level; (3) assess the
effect of increased demand on repair cost; (4) ascertain how changes in the
mix of parts in the inventory over time might lead to repair cost increases;
and (5) determine how individual surcharge elements contribute to overall
surcharge rate changes.

We are making recommendations that build on the Navy's planned studies to
increase oversight and visibility over efforts to reduce and stabilize spare
part prices and surcharges. In written comments on a draft of this report,
DOD generally agreed with our recommendations and discussed alternative
approaches for viewing price trends.

Background The Navy owns and operates about 4,000 aircraft. When any of the
components on these aircraft fail to perform properly, or reach the end of

their service life, they must be replaced with repaired or newly purchased
parts. There are about 70,000 types of aviation reparable parts. These parts
include airframes and airframe accessory equipment such as landing gear
assemblies, aircraft engines and engine accessory equipment (e. g., fuel
pumps and generators), aircraft instruments, and test equipment. These
components, in turn, are manufactured using thousands of individual parts. 5
Naval aviation depots and commercial contractors perform maintenance on
airframes, engines, and components requiring major overhaul or modification.
In fiscal year 1999, the average price paid by customers for a repaired part
was about $7,000, but it went as high as $1. 4 million per unit. Customers
paid less than $5,000 per unit for about 80 percent of the parts.

Pricing spare parts is a 2- year process that involves customers as well as
a number of Navy entities and the Office of the Under Secretary of Defense
(Comptroller). During this process, prices are set based on projected
customer requirements as well as anticipated repair and overhead costs.

5 These include other reparable parts as well as “consumable”
parts, i. e., those items that cannot be cost- effectively repaired. Most
consumable parts are managed by the Defense Logistics Agency.

Appendix II describes the budgeting and price- setting process in greater
detail.

Spare Part Prices Have Prices for all Navy- managed parts we analyzed
increased at an average

Increased With annual rate of 12 percent from fiscal year 1994 through 1999.
However,

prices for parts actually sold and for parts in frequent demand- that is,
Dramatic Fluctuations

sold every year- increased substantially more. Prices for parts unique to
From Year to Year

three weapon systems, which accounted for 34 percent of total sales in 1999,
also grew more substantially. Moreover, from year to year there were very
strong fluctuations in prices, indicating considerable price instability.

Spare Part Prices Have Prices for all Navy- managed parts- which included
about 60,000 items-

Increased for All Parts increased at an average annual rate of 12 percent
from fiscal year 1994

Managed through 1999. Many of these items did not have sales activity during
the

analysis period. As noted in table 1, sharp price increases were experienced
in 1995 and 1998.

Table 1: Percent Price Changes- All Navy- managed Parts Fiscal year

Average annual 1995 1996 1997 1998 1999 change

Annual percent change 32. 2 -15. 0 9.3 38.1 -4.5 12.0 in price
Hypothetically, if a part cost $100 in fiscal year 1994, by fiscal year 1999
the

same part would cost $162. Parts Sold to Customers

Of the approximately 60,000 Navy- managed spare parts included in our
Experienced Substantial

review, 35 percent were sold to customers at least once from fiscal year
Price Growth

1994 through 1999. About 8 percent were in frequent demand, experiencing
sales in each of the 6 years. For each of these two categories of parts, we
calculated the average annual price change and an expenditure- weighted
average annual price change. The latter approach places greater emphasis on
price changes for those parts with higher sales volume. 6

The first category- parts sold at least once- experienced more substantial
price growth than the overall population of parts, increasing at an average
annual rate of 16.7 percent versus 12 percent. As shown in table 2, parts
with higher sales volume (expenditure- weighted analysis) experienced even
higher price increases, growing at an average annual rate of 22. 6 percent.
Using the weighted average, a part costing $100 in fiscal year 1994 would
cost $258 by fiscal year 1999.

Table 2: Percent Price Changes- Parts Sold Fiscal year

Average 1995 1996 1997 1998 1999 annual change

Annual price change 46. 2 -13. 0 11.5 36.5 2. 1 16. 7

Expenditure- weighted annual price change 50. 2 0. 5 9. 7 46.0 6. 8 22. 6

The second category- parts in frequent demand- also experienced more
substantial price increases. As noted in table 3, the average annual price
increase was 19 percent and, when expenditure- weighted, the increase was 27
percent.

6 See app. I for details on expenditure- weighted calculations.

Table 3: Percent Price Changes- Parts in Frequent Demand Fiscal year

Average 1995 1996 1997 1998 1999 annual change

Annual price change 50.2 -11. 5 13. 8 37. 5 4. 6 18. 9 Expenditure- weighted

53. 3 2.5 20.5 52.0 6. 1 26. 9 annual price change Parts Unique to Select

For illustrative purposes, we examined price trends for parts unique to
Weapon Systems Have

three aircraft and their engines: the CH- 53 Sea Stallion transport
helicopter, Experienced Significant

the F/ A- 18 Hornet fighter and attack aircraft, and the AV- 8 Harrier
attack Price Growth

aircraft. In fiscal year 1999, over $500 million in revenue- over 30 percent
of total sales- was generated for parts unique to the CH- 53 Sea Stallion
transport helicopter and the F/ A- 18 Hornet fighter and attack aircraft and
their engines. Because Marine Corps officials had expressed concern about
substantial price increases for parts on the AV- 8 Harrier attack aircraft,
we also included this aircraft and its engine in the analysis. Parts unique
to the AV- 8 Harrier represented about 5 percent of total sales in fiscal
year 1999.

As shown in table 4, parts unique to all three aircraft and two of the
engines experienced price increases exceeding the 12- percent annual average
for parts managed. For example, the F/ A- 18 Hornet and the AV- 8 Harrier
and their engines showed price increases about 1.5 times higher than all
parts managed. These increases were driven by substantial price increases in
1995, when prices increased by 68 percent for the F/ A- 18 Hornet, and in
1998, when prices jumped by 70 percent and more for the AV- 8 Harrier and
its engine.

Table 4: Percent Price Changes for Selected Aircraft and Engines Fiscal year

Average 1995 1996 1997 1998 1999 annual change

AV- 8 Harrier 37.5 -18.9 -4.2 70. 0 1. 4 17. 2 Engine (F402) 39. 8 -19. 4
-5. 8 77.8 6. 5 19. 8 CH- 53 Sea Stallion 39.4 -19.4 7. 3 41. 0 1.1 13. 9
Engine (T64) 43.8 -19.8 -9.0 32. 9 6. 7 10. 9 F/ A- 18 Hornet 68. 2 -23.9 5.
8 39. 5 -1. 4 17. 6 Engine (F404) 43. 5 -20. 0 0. 2 44. 8 9. 7 15.6

Spare Part Prices Showed While parts' prices generally increased over the
analysis period, there were

Strong Fluctuations From also strong fluctuations in price. As shown in
figure 1, in 1995 and 1998,

Year to Year over 85 percent of approximately 60,000 Navy- managed parts
showed price

increases exceeding 10 percent while in 1996, prices for 84 percent of parts
managed dropped by 10 percent or more. In any given year, between 3 and 50
percent of the parts showed less than a 10- percent price change. These
extreme price changes from year to year indicate substantial price
instability.

Figure 1: Distribution of Percent Change in Prices

Percent of parts 100

80 60 40 20

0 1994- 95 1995- 96 1996- 97 1997- 98 1998- 99

Fiscal year > -30% Price decrease -10 to -30% -10 to 10% 10 to 30% > 30%
Price increase

Surcharge Rate Was As noted earlier, the price that customers pay for spare
parts is composed

Main Driver of Price of a repair cost and a surcharge rate. Both components
generally increased

over the analysis period. However, on average, over 70 percent of the price
Fluctuations

changes (increases and decreases) from fiscal year 1994 through 1999 can be
accounted for by changes in surcharge. In addition, surcharge rates have
fluctuated considerably year- to- year. These fluctuations drove the swings
in customer prices over the 6 years.

Repair Costs and Surcharge The repair cost represents the price the Navy
pays to naval aviation depots

Rates Increased or commercial contractors to repair parts. This price
consists of labor and

overhead costs at the repair facilities, as well as the cost of individual
parts that are used to refurbish the reparable parts. As noted in table 5,
repair costs increased at an average annual rate of 11.8 percent from fiscal
year 1995 through 1999. 7

Table 5: Percent Change in Repair Costs Fiscal year

Average annual 1995 1996 1997 1998 1999 change

Annual change in 16. 7 18. 0 -2.1 15.2 11.0 11. 8 repair costs
Hypothetically, a part costing $50 in 1994 would cost $86.20 by 1999 based

on these percent changes in costs. The surcharge rate is applied to an
item's repair cost to recover operating costs such as

supply operations support costs (labor, benefits, and supplies);
condemnation (the cost of replacing parts that can no longer be

repaired); shipping and transportation; depreciation; prior year gains and
losses; and inflation.

The surcharge rate is derived by dividing the estimated cost of operations
by projected sales. When the cost of operations increases and sales
decrease, increases in the surcharge rate are more dramatic. Figure 2 shows
the surcharge rates for 1994 to 1999 and the percent change from year to
year.

7 See app. IV for repair cost change distribution.

Figure 2: Surcharge Rates

53.5 36.2

32.1 28.0

20.2 14.5

1994 1995 1996 1997 1998 1999 Percent change in surcharge rate:

79% -60% 93% 91% -40%

To provide an illustrative example, if the repair cost of a spare part was
$100, customers would pay $120 based on the 1994 surcharge rate of 20. 2
percent. Assuming the repair cost remained the same, customers would have
paid $136 for the part at the higher 1995 surcharge rate of 36. 2 percent.
As shown in figure 2, surcharge rates increased from the 1994 rate in every
year except 1996.

Surcharge Fluctuations Surcharge rates fluctuated dramatically over the
analysis period, as shown

Drove Price Changes in figure 2. For instance, the surcharge rate increased
by 91 percent in 1998,

but dropped by 40 percent in the following year. We compared the year-
toyear dollar change in repair costs and surcharge amounts as a proportion
of the dollar change in customer prices 8 and found that changes in
surcharge

8 See app. I for methodology.

amounts accounted for a larger portion of the price fluctuations (increases
and decreases). On average, over the analysis period, 73 percent of the
dollar change in prices was attributable to changes in the surcharge amount.

Several Factors Contributed One reason that surcharges increased
substantially in fiscal years 1995 and

to Surcharge Fluctuations 1998 was that the Office of the Under Secretary of
Defense (Comptroller)

directed the Navy to recoup $375 million and $167 million, respectively, to
improve the financial viability of the working capital fund. These funds
were recouped by increasing the surcharge rate.

Another reason for the surcharge fluctuations was adjustments for prior year
accumulated gains and losses. 9 Defense regulations require the military
services to use accumulated operating results in determining the prices to
charge customers, with the goal of operating the supply fund on a break-
even basis over time. Large swings in the accumulated operating result
indicate that, from fiscal year 1994 through 1999, the Navy ran a surplus in
some years and large deficits in other years. In a surplus situation, the
surcharge rate is lowered; in a deficit situation, the rate is increased.

A third reason for the surcharge fluctuations was surcharge reductions made
from 1995 through 1997. These reductions were implemented to capture savings
anticipated from more efficient operations under the working capital fund.
Although the surcharge was lowered in 1996 and 1997, the savings ended in
1998, contributing to the increased rate that year.

A fourth reason for the fluctuations was that the Navy's sales base declined
in 1998. This drop in sales contributed to the high surcharge rate that
year. According to Navy documents, this was largely due to a DOD program
that required the military services to transfer responsibility for most
consumable spare parts to the Defense Logistics Agency.

Navy Shifted Costs Out of According to officials at the Office of the
Secretary of Defense and the

Surcharge Rate Navy, increases in the surcharge have become a significant
concern among

operating units. The high surcharge rate in 1998, in particular, caused an 9
This difference between revenue and expenses over a period of time longer
than a year is referred to as the accumulated operating result.

avalanche of customer complaints. In an effort to reduce the surcharge rate
and respond to customer complaints, the Navy shifted costs related to
transportation, condemnation, and obsolescence (the reduced value of assets
whose use is precluded by a change in technology or operations) from the
surcharge rate to repair costs.

In fiscal year 1999, the first year that transportation costs were removed
from the surcharge rate, about $100 million was shifted and spread across
repair costs. In 2000, about $200 million in condemnation and obsolescence
costs were applied to repair costs. According to Navy budget documents, the
initiative to remove these costs from the surcharge rate preserves the basic
tenet of full cost recovery under the working capital fund, while not
changing the customer price. In fact, the Navy stated that applying
transportation costs to repair costs better reflects the cost of goods sold
and standard industry practice. The Navy also stated that the transfer of
condemnation and obsolescence costs was done to be consistent with other
services.

However, shifting these elements out of the surcharge rate to the repair
costs did not reduce the Navy's overhead costs; it transferred them to a
different category. While in theory the customer's price remains the same,
this change masks the cost of supply operations by making it appear that the
overhead costs have dropped, when in reality they have merely been
reallocated. In addition, condemnation costs (the cost of procuring new
items to replace those that can no longer be repaired) are spread across all
spare parts, rather than being allocated to the specific parts or groups of
parts being replaced. 10 As a result, all customers are paying for these
costs, regardless of whether they are buying the parts that incur
condemnation charges. In addition, because these costs are spread across all
spare parts, they are not reflected in the specific parts that are
condemned. As such, this action may actually reduce the incentive for
managers to cut costs for certain items.

10 The Air Force applies condemnation costs to the groups of spare parts
actually incurring the costs. See Air Force Supply Management: Analysis of
Activity Group's Financial Reports, Prices, and Cash Management( GAO/ AIMD/
NSIAD- 98- 118, June 8, 1998).

Inaccurate Price As part of the price- setting process, the Navy and DOD
project an overall

Change Projections percent change in prices that customers can expect to pay
in the next

budget year. Since customers' budgets are based on this number, it is Can
Lead to Customer

critical that it be accurate and in line with the actual prices that are
Funding Shortfalls

eventually set for individual items. In recent years, however, there have
been discrepancies between projected and actual prices. Unanticipated
developments, such as the availability of new, costlier material, can result
in a mismatch between forecasted requirements and actual needs. These
differences, in turn, can cause customers to seek supplemental
appropriations or delay procurement of the parts they need.

Customer Budgets Are The projected price change, which the Navy refers to as
the annual price

Based on Projected Price change rate, is the means of ensuring that
customers' budgets are balanced,

Changes in the aggregate, with the prices of the spare parts they plan to
buy. As

mentioned earlier, the process of setting this projection, which is subject
to approval from the Office of the Under Secretary of Defense (Comptroller),
begins 2 years prior to the start of a fiscal year. 11 If actual prices are
set higher than the projected level, customers may not have sufficient funds
to buy the items they need. When funding falls short, customers must (1)
reprogram and/ or transfer funds from other accounts, (2) seek supplemental
appropriations, or (3) delay procurement of the parts they need.

The following examples further illustrate how customer funding- at the
command, activity, and field unit level- is tied to the projected price
change.

In fiscal year 1998, spare part prices, which became effective on October 1,
1997, in a process that began in the summer of 1996, were expected to
increase by 24.7 percent. This projected increase meant that Navy customers,
as a whole, would have to increase their spare parts budget by 24.7 percent
from 1997 funding levels to sufficiently cover spending requirements for
spares. After the aggregate projected rate was established, the Naval
Inventory

Control Point provided Navy commands with projected price changes by weapon
system. This information is provided each year to help activities distribute
their funding so that field units will have the funds

11 See app. II for a time line depicting the 2- year process.

they need to buy the parts for which they projected a requirement in the
budget process. Factors such as projected demand, repair cycles, and system
modifications affect the rate at the weapon system level. For some weapon
systems, the projected price change can be

significantly higher than for others. For example, in the aggregate, prices
were expected to increase by 24. 7 percent in 1998. However, the projected
price change for parts unique to the S3 Viking aircraft was 15. 5 percent,
while the price change for its engine, the TF 34, was 70. 9 percent.

Over the past several years, the overall projected price change has
fluctuated considerably. As shown in table 6, projected price changes were
highest in fiscal years 1995 and 1998. In fiscal years 1999 and 2000,
projected price changes were more moderate. However, in fiscal year 2001,
the projected price change again increased significantly. This was partly
due to a modeling error that was made in setting the 1999 price change rate.
Specifically, transportation costs were not captured and material escalation
costs were understated, resulting in a deficit for the working capital fund.
Collection of these costs began in fiscal year 2001, causing the annual
price change rate to increase to 14.3 percent for that year.

Table 6: Navy's Projected Annual Price Changes Fiscal year 1994 1995 1996
1997 1998 1999 2000 2001

Projected annual price 6. 3 28.3 -21.6 5. 7 24. 7 -3. 6 -2.9 14. 3 changes
(percent) Unanticipated

We compared actual price changes with the Navy's projected price changes
Developments Can Cause a

from fiscal years 1994 through 1999 and found that the Navy's projected
Mismatch Between Actual

changes fell short of actual price changes in 4 of the 5 years, as shown in
and Projected Prices

figure 3. Again, because customer funding is tied to the projected change,
such discrepancies can lead to funding shortfalls and possibly affect
readiness.

Figure 3: Projected Price Change Rate Compared to Actual Price Change

50 In percent

40 30 20 10

0 1995 1996 1997 1998 1999

-10 -20 -30

Actual price change Projected price change

With sales prices based on assumptions that are made as long as 2 years
before the prices go into effect, some variance between expected and actual
costs is inevitable. Weapon system managers and other Navy officials noted
that unanticipated developments can result in a mismatch between actual
needs and forecasted requirements. For example:

DOD may initiate logistics engineering changes that call for replacing
selected items with more reliable or easily maintained substitutes. These
modifications, while initially costly, are intended to improve the
performance and value of the weapon system from a total life- cycle
perspective. However, the Navy has found that implementing such changes has
cost more than originally anticipated. According to a Navy document,
customers have had insufficient resources allotted in the budget process to
pay for the new, improved items. Unexpected delays in developing a new
system may occur. The annual

price change is based on the forecasted availability of the system, but if

it is not ready when projected, the Navy must continue to pay higher costs
to maintain the old system that it is replacing. New and improved material
is available, but its cost was not built into

the projections established 2 years prior. Thus, customers have insufficient
funds to pay for the material. For example, during the pricesetting process
for fiscal year 1998, the Navy estimated that it would require modifications
to a high- pressure turbine rotor- a major component of the F 402 engine on
the AV- 8B aircraft. However, it did not anticipate having to replace all of
the blades on the rotor with new material, a situation that occurred because
the old and new materials could not be intermingled on the rotor. This
unexpected extra work and the cost of new material for all of the blades
drove up the price of the rotor from an estimated price of $30, 350 to an
actual price of $853,890- a 2, 713- percent increase. Because the higher
price was not reflected in the projected 1998 annual price change rate, the
Navy fleet's budget had not been adjusted to cover the repair costs. Thus,
the Navy Working Capital Fund absorbed the cost so as not to adversely
affect the fleet's budgets. In 1999, the customers' price reflected the
higher cost.

Customers can experience funding problems when forecasted budgetary needs
are inaccurate. According to DOD officials, funding in 1997 was insufficient
because flying hour projections were too low. These inaccurate estimates, in
turn, resulted in an understated projected price change and underfunded
customer budgets. As a result, customers lacked the funds necessary to pay
for aircraft spare parts, and the Navy could not collect sufficient revenue
to pay for the spare parts their customers needed. To address this problem,
the Navy allocated $116 million of a fiscal year 1999 supplemental
appropriation to purchase aviation spare parts. These funds were used to buy
parts that had been deferred in 1997 and to reduce subsequent backlogs in
repair work.

Navy Studies Focus on The Navy has recognized that increasing and unstable
prices can affect

Pricing- Related readiness and has conducted studies to determine the causes
of the price

increases and recommend improvements. A 1998 report on Naval Aviation
Problems

Maintenance and Supply Readiness identified price increases for aviation
spares as a key concern that could affect readiness. The Navy has identified
100 specific parts as cost drivers- those with the highest price increases
and the most demand. The report noted that decreasing the cost and/ or
improving the reliability of these components would significantly enhance
readiness. The report also stated that difficulties in accurately projecting
flying hour costs has led to underfunding, which, in turn, could have caused

a decline in readiness. The report concluded that improving the accuracy of
budget forecasting would help address this problem.

According to a recent study update, engineering and design changes and other
modifications have increased the reliability and stability of prices for
several of the items. However, current price trends were expected to
continue for other items. The Navy also noted that gathering detailed demand
and repair cost data at the item level is a very labor- intensive process.

In October 1999, the Deputy Chief of Naval Operations (Logistics) directed a
study group to review aviation repair pricing processes, determine the
extent of pricing problems, and recommend corrective actions. Further, in a
July 2000 report, the Center for Naval Analyses found that aviation spare
part costs have grown rapidly since the early 1990s. The Center is
undertaking a series of follow- on studies that include assessing

the effect of certain weapon systems on cost changes at the aggregate level,
the impact of increased demand on cost, the effect of changes in the mix of
parts in the inventory over time on

cost increases, the differences between commercial and naval aviation depot
repair

costs for similar items, the price impact of the “consumable”
material- that is, parts that are

consumed in use- on aviation spares part costs, and the effect of changes in
the surcharge elements on overall surcharge

change. Conclusions Aviation spare parts prices- especially those in
frequent demand- have

experienced substantial increases. Moreover, there were dramatic price
fluctuations from year to year, largely due to surcharge rate changes. The
Navy's plans to further study the underlying causes of price increases
appropriately focus on answering questions such as what are the reasons
behind repair cost increases, which weapon systems drive aggregate cost
changes, what effect does increased demand have on prices, and what elements
are driving surcharge rate changes. Nevertheless, it will be important for
DOD to ensure that the Navy follows through on the study results by
identifying and implementing appropriate corrective actions. In addition,
the Navy has sought to alleviate customer concerns about high surcharge
rates by moving certain overhead costs from the surcharge to

repair costs. However, this approach merely reallocated the overhead costs,
rather than reducing them. Also, condemnation costs, now part of the repair
costs, continue to be spread among all spares rather than allocated at the
item level, potentially reducing managers' incentive for controlling these
costs.

Recommendations for We recommend that the Secretary of Defense ensure that
the Navy follows

Executive Action through on the results of its planned studies by
identifying and

implementing solutions to reduce and stabilize prices and surcharge rates.
We also recommend that the Secretary of Defense direct the Navy to allocate
condemnation costs to the specific parts or groups of parts incurring the
costs. If this allocation cannot be achieved, we recommend that condemnation
costs be reflected in the surcharge rate. Finally, we recommend that the
Secretary of Defense report to the Congress on the Navy's progress in (1)
reducing and stabilizing prices and surcharge rates and (2) allocating
condemnation costs at the item level.

Agency Comments and In written comments on a draft of this report, DOD
generally agreed with

Our Evaluation our principal findings and recommendations. DOD noted that
certain

approaches to cost analysis, such as studies of unit cost trends (the
subject of this report) or cost per flight hour (the subject of recent
studies by the Center for Naval Analyses), may overlook reliability
improvements that are intended to reduce total costs. We do not disagree
with this assertion. However, we believe it is important to continue to
track unit price increases as part of assessments regarding the
effectiveness and efficiency of reliability improvements.

DOD agreed with our recommendation that the Department carry out planned
studies concerning the reduction and stabilization of prices and the
surcharge rate. The agency, however, asserted that our report implies that
the surcharge rate is the primary driver of price escalation. This statement
is incorrect. Our report states that the surcharge rate was the primary
driver of price fluctuation (both increases and decreases), not price
escalation alone.

Regarding our recommendation to allocate condemnation costs to the specific
parts or groups of parts incurring the costs, DOD stated that it had begun
to allocate these costs beginning in fiscal year 2001. DOD plans to refine
its cost allocation methodology to raise the level of attention on

items with low survival rates and drive reliability improvements where
possible.

DOD agreed to report to Congress, using traditional means such as the
President's budget submission. We believe that the President's budget
submission would be a reasonable vehicle for reporting to Congress on the
results of the Navy's ongoing studies and on the Department's progress in
reducing and stabilizing prices and surcharge rates. However, if this
mechanism is used, these topics should be highlighted in a separate section
and discussed in detail.

The Department's comments appear in appendix V. We are sending copies of
this report to the appropriate congressional committees; the Honorable
William S. Cohen, Secretary of Defense; the Honorable Richard Danzig,
Secretary of the Navy; General James L. Jones, Commandant of the Marine
Corps; and the Honorable Jacob J. Lew, Director, Office of Management and
Budget.

GAO contacts and major contributors to this report are listed in appendix
VI.

David E. Cooper, Director Acquisition and Sourcing Management

Appendi Appendi xes xI

Scope and Methodology To evaluate trends in Navy aviation spare part prices,
we obtained repair, net, standard, and procurement price data for the
approximately 70,000 Navy- managed depot level aviation reparables from the
Naval Inventory Control Point- Philadelphia. This information was obtained
from the Navy's Master Item File-a database containing reparable prices and
other technical data. The Naval Inventory Control Point also provided us
with billing records extracted from the Billing History File. Furthermore,
we collected information about the aviation reparable budgeting and pricing
cycle and reviewed Department of Defense (DOD) and Navy financial management
and budget regulations and our reports.

We did not request data on the consumable spare parts that are still under
the Navy's purview because we conducted a separate review of the Defense
Logistics Agency's consumable spare part prices. About 95 percent of
consumable spares are now managed by the Defense Logistics Agency.

We did not validate or verify the pricing data the Naval Inventory Control
Point provided. However, we took several steps to address data quality.
Specifically, we reviewed the data and performed various quality checks,
which revealed some discrepancies in the data. We discussed these
discrepancies with Inventory Control Point officials and where appropriate
deleted the data from our analysis universe.

Analysis Universe Customers are charged the net price when they turn in a
broken item to be repaired; otherwise they pay the higher, standard price.
Because over 90

percent of the time customers pay the net price, we focused our analysis on
this price. We excluded parts that did not have a National Item
Identification Number (these parts have not been catalogued). These parts
are classified as bachelors, family heads, or family members. 1 We limited
our price trend analysis to bachelors and family heads in a particular year
and excluded family members.

Preliminary percent change distributions revealed a small number of extreme
price changes. Between fiscal year 1995 and 1999, about 99 percent of the
parts experienced price changes under 500 percent. However, approximately 1
percent showed price changes from 500 percent

1 Parts in the same family have a similar form, fit, and function. Prices
for head and member parts in the same family are based on the repair cost
resident with the family head, plus the surcharge rate.

to over 100,000 percent. Because these extreme values skewed our average
annual price change, we set aside parts in the 1- percent tail ends of the
percent change distribution from our price trend analysis. Table 7 shows the
average price change with and without extreme values.

Table 7: Average Price Change With and Without Extreme Values Fiscal year

Average 1995 1996 1997 1998 1999 annual change

Percent price change (all 48. 8 11.7 23. 5 54.0 108. 6 parts) 49. 3

Percent price change 32. 2 -15.0 9. 3 38. 1 -4. 5 12. 0

(removed 1- percent tail ends)

After applying these filters, our analysis universe included about 51,000 to
52, 000 of the approximately 70, 000 Navy- managed spare parts in any given
year. Over the analysis period, we examined about 60,000 parts. Since some
spare parts have been removed or introduced to the Navy's inventory over
time, these 60,000 spare parts do not represent a market basket. All
findings in this report are based on these modifications.

Price Trend Analysis To assess whether spare parts' prices have increased,
decreased, or remained the same over time, we calculated the year- to- year
percentage change in prices for each of the approximately 60,000 parts and
the average annual price change for each year. We also looked at the price
change distributions. Because the price change distributions varied
drastically from year to year, we chose the 10- percent change as a
benchmark of relative price stability. Although we did not identify a
comparable indicator to assess price changes in aviation spares, we used as
a proxy the Bureau of Labor Statistics' Producer Price Index commodity group
“Intermediate Materials, Supplies, and Components/ Materials and
Components for Manufacturing.” Between 1994 and 1999, prices for
materials used in the production of goods in this index changed between -0.2
and 1.6 percent and averaged 0.3 percent over this period.

Parts sold to customers We used billing records to identify spare parts sold
to customers and the dollar value of total sales. 2 The Naval Inventory
Control Point sold approximately 10, 000 to 12, 000 types of spare parts
each year. 3 Since customers buy different types of spare parts from year to
year, we do not have a market basket of spares. Over the analysis period,
customers bought about 21, 000 different types of parts (35 percent of the
parts examined). We calculated the average annual percent change in prices
and expenditureweighted average annual percent change in prices for this
subset of parts. Under this latter approach, parts with higher sales
received larger weights and greater emphasis. Weights were calculated by
dividing total sales for each spare part into total sales for a given year.
These weights were applied to percent changes for parts sold to determine
the expenditure- weighted price changes. In addition to parts sold, we
calculated the average annual percent change and the expenditure- weighted
average annual percent change for frequent- demand parts - those sold in all
6 years of our analysis period. There were about 5,000 frequent- demand
parts.

Aircraft and federal supply We calculated the annual average price change
for various subsets of parts

groups by selecting parts unique to the F/ A- 18 Hornet, the CH- 53 Sea
Stallion, the

AV- 8 Harrier, and their engines (F404, T64, and F402). To identify these
parts, we used weapon system codes. We also examined price trends for the
five federal supply groups that had the highest sales in fiscal year 1999.
To identify these groups of parts, we used the federal supply group, a
component of each part's national stock number.

Analysis of Repair Costs and The price that customers pay for spare parts is
repair cost plus the

Surcharge Contributions to surcharge amount. Theoretically, the change in
repair cost plus the change

Price Change in surcharge amount equals the new price. To determine how much
the

repair component and the surcharge component were contributing to price
trends, we calculated the change in repair costs and the change in surcharge
amount as a proportion of the change in price (increases and decreases).
Table 8 is an example of the calculation used.

2 See section on billing transaction analysis for more information about
transactions retained for this analysis. 3 We limited parts sold to
bachelors and family heads.

Table 8: Example of Calculation Used to Determine Percentage of Price Change
Attributable to Repair Versus Surcharge

Fiscal year Servocylinder (part unique to the F/ A- 18 Hornet) 1994 1995
1996 1997 1998 1999

Repair component $5, 380 $5, 483 $4, 846 $5, 929 $6, 917 $6, 108 Surcharge
component 1, 090 1, 987 704 1, 661 3,703 1, 962

Price $6,470 $7,470 $5,550 $7,590 $10, 620 $8, 070

Dollar change in repair a $103 ($ 637) $1, 083 $988 ($ 809) Dollar change in
surcharge 897 (1,283) 957 2, 042 (1, 741)

Dollar change in price $1,000 ($ 1, 920) $2, 040 $3, 030 ($ 2, 550)

Percent of price change 10 33 53 33 32

attributable to repair b Percent of price change 90 67 47 67 68 attributable
to surcharge a Dollar change is the price in the current year subtracted
from the prior year.

b The percentage of change attributable to repair is the change in repair
divided by the change in price and then multiplied by 100.

We did not examine the direction of change, that is, whether prices
increased or decreased. Our primary interest was to determine which
component had a larger effect on the observed price fluctuations. This
calculation was performed for the approximately 60,000 parts that were
bachelors and family heads.

Billing Transactions We used the Navy's Billing History File to identify
parts sold to customers

Analysis and total sales for parts sold. We performed several data checks
and

excluded transactions from the billing data that met the following criteria.
Transactions for consumable parts. Transactions that did not have a National
Item Identification Number

(customers normally are not billed for these parts). Transactions where
customers were charged a price that did not appear

in the Master Item File in any of the 6 years. Transactions, which totaled
about $100 million in 1998, that had been

mistakenly coded as standard sales rather than net sales due to a computing
error. We moved this $100 million into our fiscal year 1998 net sales.

Transactions for family member parts. Transactions where sales summed to a
negative number (i. e., credits

exceeded bills for a requisition in a given year). All analyses requiring
billing information were based on this modified database.

Reasons for Surcharge To determine possible reasons for changes in the
surcharge rate, we

Fluctuations reviewed financial management regulations, the Navy's budget
guidance,

and Working Capital Fund budget estimate justifications. We also interviewed
Office of the Under Secretary of Defense (Comptroller) and Navy officials.
We used price data to verify that surcharge rates were consistently applied.

We performed our review at the Office of the Under Secretary of Defense
(Comptroller)/ Revolving Fund Directorate, Washington, D. C.; the Under
Secretary of Defense (Comptroller)/ Program Analysis and Evaluation,
Washington, D. C.; the Navy/ Financial Management and Comptroller, Crystal
City, Virginia; the Chief of Naval Operations/ Air Warfare Division,
Washington, D. C.; the Naval Supply Systems Command, Mechanicsburg,
Pennsylvania; the Naval Inventory Control Point- Philadelphia, Pennsylvania;
the Naval Aviation Depot, Cherry Point, North Carolina; and the 2nd Marine
Air Wing, Cherry Point, North Carolina. We conducted our review from
February 1999 through August 2000 in accordance with generally accepted
government auditing standards.

Budgeting and Price- setting Process for Fiscal

Appendi xII

Year 2000 NAVICP

Sends sales projections for FY 2000 Fleet

6/ 98

NAVSUP

Submits Proposes surcharge rate and annual

projected price change rate

budget for FY 2000

NAVY/ FMB

Adjusts annual price change rate to balance with customer budgets

9/ 98 Agencies submit initial

OSD/ C

FY 2000 request to OMB Reviews price change rate

Submits 10/ 98 FY 1999 begins

Approves rate updated

FY 1999 prices executed requirements

Fleet NAVSUP

Prepares FY 2000 budget using price change rate

Sends estimated surcharge rate and approved price change rate

2/ 99 President submits FY 2000

budget proposal to the Congress

NAVICP

Sets new prices based on updated Appropriations hearings

demand and repair and begin

procurement costs Adjusts surcharge rate to achieve 4/ 99

approved annual price change rate Proposes final surcharge rate 6/ 99

NAVSUP

Approves final surcharge rate 8/ 99

NAVICP

Issues price change rate by weapon system 9/ 99

Congress completes action on appropriations bills

Fleet

10/ 99 FY 2000 begins FY 2000 prices executed

NAVICP - Naval Inventory Control Point

OSD/ C - Office of the Under Secretary of Defense (Comptroller)

NAVSUP - Naval Supply Systems Command

OMB - Office of Management and Budget

NAVY/ FMB - Navy Financial Management and Comptroller

Appendi xI II

Federal Supply Groups The Department of Defense uses a two- digit federal
supply group code to categorize and manage its spare parts, in addition to a
unique nine- digit national item identification number. Table 9 summarizes
the average annual price change for the five supply groups with the highest
sales.

Table 9: Annual Percent Change in Prices by Federal Supply Group Fiscal year

Average annual 1995 1996 1997 1998 1999

change

Electrical and electronic equipment 31. 7 -20.3 7. 9 33. 9 -5.7 9. 5
components Communication, detection, and

33. 9 -13.9 7. 3 35. 5 -5.1 11. 5 coherent radiation equipment Instruments
and laboratory equipment 31. 1 -12.9 9. 7 39. 7 -4.0 12. 7

Aircraft components and accessories 37. 0 -12.0 9. 9 43. 7 -1.6 15. 4
Engine, turbines, and components 29.0 -5. 4 16.6 41.9 -4. 9 15.4 All other
federal supply groups 31. 0 -13.0 10. 7 41. 1 -3.9 13. 2

Appendi xI V

Repair Cost Change Distribution Percent of parts 100

80 60 40 20

0 1994- 95 1995- 96 1996- 97 1997- 98 1998- 99

Fiscal year > -30% Price decrease -10 to -30% -10 to 10% 10 to 30% > 30%
Price increase e

Note: Repair cost is one component of the customer's price.

Appendi xV Comments From the Department of Defense

Appendi xVI

GAO Contact and Staff Acknowledgments GAO Contact Karen S. Zuckerstein (202)
512- 6785 Acknowledgments In addition to those named above, Michele Mackin,
Yeewan Tom, and

Charles Perdue made key contributions to this report. Gregory E. Pugnetti
served as advisor.

(707458) Lett er

Ordering Information The first copy of each GAO report is free. Additional
copies of reports are $2 each. A check or money order should be made out to

the Superintendent of Documents. VISA and MasterCard credit cards are
accepted, also.

Orders for 100 or more copies to be mailed to a single address are
discounted 25 percent.

Orders by mail: U. S. General Accounting Office P. O. Box 37050 Washington,
DC 20013

Orders by visiting: Room 1100 700 4th St. NW (corner of 4th and G Sts. NW)
U. S. General Accounting Office Washington, DC

Orders by phone: (202) 512- 6000 fax: (202) 512- 6061 TDD (202) 512- 2537

Each day, GAO issues a list of newly available reports and testimony. To
receive facsimile copies of the daily list or any list from the past 30
days, please call (202) 512- 6000 using a touchtone phone. A recorded menu
will provide information on how to obtain these lists.

Orders by Internet: For information on how to access GAO reports on the
Internet, send an e- mail message with “info” in the body to:
info@ www. gao. gov or visit GAO's World Wide Web home page at: http:// www.
gao. gov

To Report Fraud,

Contact one:

Waste, or Abuse in

Web site: http:// www. gao. gov/ fraudnet/ fraudnet. htm

Federal Programs

e- mail: fraudnet@ gao. gov 1- 800- 424- 5454 (automated answering system)

GAO United States General Accounting Office

Page 1 GAO- 01- 23 Navy Aviation Spare Parts

Contents

Page 2 GAO- 01- 23 Navy Aviation Spare Parts

Page 3 GAO- 01- 23 Navy Aviation Spare Parts United States General
Accounting Office

Washington, D. C. 20548 Page 3 GAO- 01- 23 Navy Aviation Spare Parts

Page 4 GAO- 01- 23 Navy Aviation Spare Parts

Page 5 GAO- 01- 23 Navy Aviation Spare Parts

Page 6 GAO- 01- 23 Navy Aviation Spare Parts

Page 7 GAO- 01- 23 Navy Aviation Spare Parts

Page 8 GAO- 01- 23 Navy Aviation Spare Parts

Page 9 GAO- 01- 23 Navy Aviation Spare Parts

Page 10 GAO- 01- 23 Navy Aviation Spare Parts

Page 11 GAO- 01- 23 Navy Aviation Spare Parts

Page 12 GAO- 01- 23 Navy Aviation Spare Parts

Page 13 GAO- 01- 23 Navy Aviation Spare Parts

Page 14 GAO- 01- 23 Navy Aviation Spare Parts

Page 15 GAO- 01- 23 Navy Aviation Spare Parts

Page 16 GAO- 01- 23 Navy Aviation Spare Parts

Page 17 GAO- 01- 23 Navy Aviation Spare Parts

Page 18 GAO- 01- 23 Navy Aviation Spare Parts

Page 19 GAO- 01- 23 Navy Aviation Spare Parts

Page 20 GAO- 01- 23 Navy Aviation Spare Parts

Page 21 GAO- 01- 23 Navy Aviation Spare Parts

Page 22 GAO- 01- 23 Navy Aviation Spare Parts

Page 23 GAO- 01- 23 Navy Aviation Spare Parts

Page 24 GAO- 01- 23 Navy Aviation Spare Parts

Appendix I

Appendix I Scope and Methodology

Page 25 GAO- 01- 23 Navy Aviation Spare Parts

Appendix I Scope and Methodology

Page 26 GAO- 01- 23 Navy Aviation Spare Parts

Appendix I Scope and Methodology

Page 27 GAO- 01- 23 Navy Aviation Spare Parts

Appendix I Scope and Methodology

Page 28 GAO- 01- 23 Navy Aviation Spare Parts

Page 29 GAO- 01- 23 Navy Aviation Spare Parts

Appendix II

Page 30 GAO- 01- 23 Navy Aviation Spare Parts

Appendix III

Page 31 GAO- 01- 23 Navy Aviation Spare Parts

Appendix IV

Page 32 GAO- 01- 23 Navy Aviation Spare Parts

Appendix V

Appendix V Comments From the Department of Defense

Page 33 GAO- 01- 23 Navy Aviation Spare Parts

Appendix V Comments From the Department of Defense

Page 34 GAO- 01- 23 Navy Aviation Spare Parts

Appendix V Comments From the Department of Defense

Page 35 GAO- 01- 23 Navy Aviation Spare Parts

Page 36 GAO- 01- 23 Navy Aviation Spare Parts

Appendix VI

United States General Accounting Office Washington, D. C. 20548- 0001

Official Business Penalty for Private Use $300

Address Correction Requested Bulk Rate

Postage & Fees Paid GAO Permit No. GI00
*** End of document. ***