Defense Management: Better Guidance Needed in Selecting Operating
Methods for Name-Brand, Fast-Food Restaurants (24-AUG-01,	 
GAO-01-683).							 
								 
The military exchange services operate a wide range of retail	 
activities such as department stores, florist shops, barber and  
beauty shops, gasoline stations, and restaurants. Hamburger	 
restaurants represent a major segment of the exchange services'  
name-brand, fast-food sales. The exchange services use either a  
direct or an indirect method to operate these restaurants. Under 
the direct method, the exchange service enters into a franchise  
agreement with a name-brand company to sell its product on a	 
military installation. As the franchisee, the exchange service	 
builds and operates the restaurants and directly employs and	 
trains the personnel. In turn, the exchange service receives all 
of the revenues and profits and usually pays the company a	 
licensing fee plus a percentage of the restaurant sales. Under	 
the indirect method, the exchange service contracts with a	 
name-brand company that, in turn, builds the restaurant and	 
either operates it as a company restaurant or provides a licensed
operator. The company or its licensed operator hires, trains, and
pays the restaurant personnel and usually pays annual fees and	 
commissions to the exchange service based on restaurant sales.	 
Under this agreement, the exchange service receives a percentage 
of the restaurants' annual sales, annual licensing fees, and, in 
some cases, a signing bonus or minimum guaranteed commissions.	 
GAO's analysis of fiscal year 1998 and 1999 financial data from  
the Army and Air Force Exchange Service and the Navy Exchange	 
Service Command showed that the indirect method of operating	 
name-brand hamburger restaurants was more profitable than the	 
direct method, regardless of the restaurants' sales volume,	 
restaurant type (free-standing or part of a food court), or	 
location. GAO's investment analysis projected that if new	 
name-brand, hamburger restaurants were to be built, the indirect 
method would provide a greater return on investment over a	 
20-year period. Other factors that are important in choosing	 
between direct and indirect methods include financial and	 
operating risks, customer service issues, employment		 
opportunities for military dependents, and management control of 
restaurant operations. While the Department of Defense's (DOD)	 
policy on name-brand, fast-food restaurants establishes 	 
preferences for when the direct and indirect methods should be	 
used, it does not provide sufficient guidance or criteria for	 
determining which method to use or when it is appropriate to	 
deviate from the policy. Also, DOD has not been actively involved
in monitoring compliance with the policy. As a result, the	 
exchanges have, over time, adopted operating philosophies and	 
business models that they believe best suit their particular	 
circumstances.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-01-683 					        
    ACCNO:   A01653						        
    TITLE:   Defense Management: Better Guidance Needed in Selecting  
             Operating Methods for Name-Brand, Fast-Food Restaurants          
     DATE:   08/24/2001 
  SUBJECT:   Food facilities					 
	     Retail facilities					 
	     Food services contracts				 
	     Post exchanges					 
	     Standards and standardization			 

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GAO-01-683
     
Report to the Chairman and Ranking Minority Member, Special Oversight Panel
on Morale, Welfare, and Recreation, Committee on Armed Services, House of
Representatives

United States General Accounting Office

GAO

August 2001 DEFENSE MANAGEMENT

Better Guidance Needed in Selecting Operating Methods for Name- Brand,
FastFood Restaurants

GAO- 01- 683

Page i GAO- 01- 683 Defense Management Letter 1

Results in Brief 3 Background 5 The Indirect Method Has Been More Profitable
for the Exchange

Services 7 Factors Other Than Profitability Are Important When Choosing an

Operating Method 16 DOD?s Policy Lacks Guidance for Evaluating Operating
Methods

and Criteria for Approving Deviations From the Policy 20 Conclusion 22
Recommendation for Executive Action 22 Agency Comments 23

Appendix I Scope and Methodology 25

Appendix II Fiscal Year 1999 Inventory of AAFES and NEXCOM Fast- Food
Restaurants 32

Appendix III Comments From the Department of Defense 33

Appendix IV Staff Acknowledgments 36

Glossary 37

Tables

Table 1: Fiscal Year 1998 and 1999 AAFES and NEXCOM Hamburger Restaurants?
Profitability (For the Periods Feb. 1, 1998 - Jan. 31, 1999, and Feb. 1,
1999 - Jan. 31, 2000) 8 Table 2: Profitability of Name- Brand, Hamburger
Restaurants by

Sales Volume 11 Table 3: Profitability of Name- Brand, Hamburger Restaurants
by

Restaurant Type 11 Contents

Page ii GAO- 01- 683 Defense Management

Table 4: Profitability of Name- Brand, Hamburger Restaurants by Location 12
Table 5: 20- Year Net Present Value of Discounted Cash Flows for

the Direct and Indirect Methods - Free- standing and Food Court Name- Brand,
Hamburger Restaurants (Fiscal Years 1998 and 1999) 13 Table 6: Factors That
Benefit the Direct and Indirect Methods 16

Figure

Figure 1: Military Exchanges? Food Sales for Fiscal Year 1999 6

Abbreviations

AAFES Army and Air Force Exchange Service DOD Department of Defense NEXCOM
Navy Exchange Service Command MCCS Marine Corps Community Services MWR
morale, welfare, and recreation

Page 1 GAO- 01- 683 Defense Management

August 24, 2001 The Honorable Roscoe G. Bartlett Chairman The Honorable
Robert A. Underwood Ranking Minority Member Special Oversight Panel on

Morale, Welfare, and Recreation Committee on Armed Services House of
Representatives

The military exchange services operate a wide range of retail activities
such as department stores, florist shops, barber and beauty shops, gasoline
stations, and restaurants. Profits from these activities provide funds for
the Department of Defense?s (DOD) morale, welfare, and recreation programs.
In recent years, the exchange services? annual sales exceeded $9 billion- in
fiscal year 1999 about $734 million involved food operations. 1 About 50
percent of the food sales came from about 615 name- brand, fast- food
restaurants (e. g., McDonald?s, Burger King, Subway, and Pizza Hut)
operating on military installations around the world. Name- brand, fast-
food restaurant operations, particularly hamburger restaurants, are the
topic of this report. It focuses on hamburger restaurants because they
represent a major segment of the exchange services? name- brand, fast- food
sales and because exchange services? contracts with two large companies,
Burger King and McDonald?s, will expire in 2004.

The exchange services use either a direct or an indirect method to operate
name- brand, fast- food restaurants. A DOD policy, issued in 1988, expresses
a preference for the direct method at overseas installations and the
indirect method at U. S. installations. Under the direct method, the
exchange service enters into a franchise agreement with a name- brand
company to sell its product on a military installation. As the franchisee,
the exchange service builds and operates the restaurants and directly
employs and trains the personnel. In return, the exchange service receives
all revenues and profits and usually pays the company a licensing fee plus a

1 The sales total includes sales from activities operated by the exchange
service and from activities operated by concessionaires under contract with
the exchange services, which include some food operations.

United States General Accounting Office Washington, DC 20548

Page 2 GAO- 01- 683 Defense Management

percentage of the restaurant sales. Under the indirect method, the exchange
service contracts with a name- brand company that, in turn, builds the
restaurant and either operates it as a company restaurant or provides a
licensed operator. The company or its licensed operator hires, trains, and
pays the restaurant personnel and usually pays annual fees and commissions
to the exchange service based on restaurant sales. Under this arrangement,
the exchange service receives a percentage of the restaurants? annual sales,
annual licensing fees, and, in some cases, a signing bonus and/ or minimum
guaranteed commissions. The size of the bonus and guaranteed payments are
determined through negotiations. With respect to name- brand, hamburger
operations, the Army and Air Force Exchange Service uses the direct method
to operate most of its hamburger restaurants, which are primarily Burger
King, while the Navy Exchange Service Command uses the indirect method to
operate most of its restaurants, which are primarily McDonald?s.

In June 2000, representatives of the largest exchange service, the Army and
Air Force Exchange Service, briefed a member of the House Special Oversight
Panel on the profitability of the direct and indirect methods of operating
name- brand, fast- food restaurants on military installations. Because the
briefing did not address all of the Panel member?s questions about the costs
and profitability of the two methods, the former Chairman and Ranking
Minority Member of the Special Oversight Panel asked us to review the two
methods. This report discusses (1) which method is more profitable 2 and
provides the greater return on investment; (2) other factors that can
influence the choice between the direct and indirect methods; and (3)
whether DOD?s policy on name- brand, fast- food operations provides adequate
guidance for determining which method to use.

Our analysis of profitability and return on investment compared only the
name- brand, hamburger restaurants operated by the two largest exchange
services- the Army and Air Force Exchange Service and the Navy Exchange
Service Command. Sales from these restaurants, primarily

2 In this report, the terms ?profit? and ?profitability? refer to economic
earnings for the direct method of operation or net profit for the indirect
method of operation. Throughout this report, profits and profitability are
expressed as a percentage of restaurant sales. Profitability under the
direct method represents a restaurant?s total revenues less its operating
costs, overhead costs, and the opportunity cost associated with invested
capital (also known as cost of capital). Profitability under the indirect
method represents the revenues (sales commissions, signing bonuses, and
licensing fees) received from the namebrand company less the exchange
service?s overhead costs. Profitability and cost of capital are discussed in
more detail in appendix I.

Page 3 GAO- 01- 683 Defense Management

Burger King and McDonald?s, represented about 50 percent of the exchange
services? total name- brand, fast- food sales in fiscal years 1998 and 1999,
the 2 years that formed the basis of our analysis. 3 Our analysis of
profitability involved and relied on information provided to us by the
exchange services. We performed procedures to evaluate the reasonableness of
the exchange services? data but did not verify its accuracy or reliability.
More information on the scope and methodology of our work is included in
appendix I.

Our analysis of fiscal year 1998 and 1999 financial data from the two
exchange services showed that the indirect method of operating name- brand,
hamburger restaurants was more profitable than the direct method. In each of
the 2 years, for example, the Navy Exchange Service Command?s profits were
about 11.5 percent of restaurant sales. In comparison, the Army and Air
Force Exchange Service?s profits were 7.8 percent and 5.5 percent of
restaurant sales, respectively. The indirect method was also more
profitable, regardless of the restaurants? sales volume, restaurant type
(free- standing or part of a food court), or location (continental United
States or overseas). Also, our investment analysis projected that if new
name- brand, hamburger restaurants were to be built, the indirect method
would provide a greater return on investment over a 20- year period. 4

Profitability or return on investment, however, has not always been the
deciding factor when military exchanges select an operating method for fast-
food restaurants. Other factors (e. g., financial and operating risks,
customer service issues, employment opportunities for military dependents,
and management control of restaurant operations) were also important in
choosing between the direct and indirect methods. Officials of the Army and
Air Force Exchange Service said that the direct method best suits their
mission objectives because the exchange can directly operate unprofitable
restaurants in remote locations or overseas for the purpose of maintaining
or boosting servicemembers? morale. Name- brand

3 In general, the fiscal year for the exchange services covers the period
from February 1st of a given year to January 31st of the following year.
This period is consistent with the fiscal year used by the retail industry.

4 The investment analysis was based on present value techniques that
consider variables such as sales, costs, capital investment requirements,
and inflation rates. In essence, the analysis compared discounted cash
flows, both outlays and revenues, expected over a 20- year period. This
analytical technique is discussed in more detail on p. 12 and in appendix I.
Results in Brief

Page 4 GAO- 01- 683 Defense Management

companies operating under the indirect method are not likely to build and
operate restaurants in such dangerous or unprofitable locations. The direct
method also provides the exchange service with greater management control
over restaurant operations and more flexibility in providing employment
opportunities to military dependents. In addition, the direct method allows
the Army and Air Force Exchange Service to take advantage of its existing
infrastructure (i. e., warehousing and distribution capabilities) to support
rapid mobilizations to such locations as Bosnia. On the other hand, the
indirect method requires very little, if any, investment. The Navy Exchange,
for example, has no capital invested in its 64 restaurants, which were built
by a name- brand, food service company, while the Army and Air Force
Exchange Service has invested over $131 million in its 171 hamburger
restaurants. The indirect method also minimizes the potential liabilities
and risks associated with operating restaurants and reduces the federal
government?s competition with the private sector, which is one of the
objectives of the Department?s fast- food policy.

While DOD?s policy on name- brand, fast- food restaurants establishes
preferences for when the direct and indirect methods should be used, it does
not provide sufficient guidance or criteria for determining which method to
use or when it is appropriate to deviate from the policy. In addition, DOD
has not been actively involved in monitoring compliance with the policy. As
a result, the exchanges have, over time, adopted operating philosophies and
business models that they believe best suit their particular circumstances.
Because of the exchanges? preferences and operating philosophies, they do
not routinely develop a business case analysis, which would include weighing
financial benefits with other factors, when determining which operating
method would be the most beneficial. However, a 1998 departmental
instruction, which addresses public- private ventures, has the potential to
give greater visibility to this issue. 5 The instruction requires the
exchange services to consider public- private ventures as an alternative
source to meet capital requirements that exceed $1 million. Each public-
private venture requires an economic analysis. Also, it is to be reviewed by
DOD policy officials when it involves an overseas restaurant or liabilities
to the government or

5 A public- private venture, as used here, is an agreement between a DOD
nonappropriated fund activity, such as an exchange service, and a non-
federal entity under which the entity provides goods, services, or
facilities to authorized morale, welfare, and recreation activities and
exchange patrons. The non- federal entity may provide a portion or all of
the financing, design, construction, equipment, and staffing associated with
the activity.

Page 5 GAO- 01- 683 Defense Management

a nonappropriated fund activity in excess of $500,000. Thus far, however,
the instruction has had no impact on the exchange services? restaurant
operations because contracts for most name- brand, fast- food restaurants
were in place before the instruction was issued. Moreover, it is not yet
clear how the instruction will be integrated with DOD?s name- brand, fast-
food policy.

We are making recommendations to improve the Department of Defense?s policy
for operating name- brand, fast- food restaurants by clarifying when
deviations from the policy can occur and by developing a more formal
decision- making process for choosing between the direct and indirect
methods of operation. In written comments on a draft of this report, DOD
concurred with our conclusions and recommendations.

The military exchanges are nonappropriated fund activities that are
established, controlled by, and operated for the benefit of DOD components.
Their mission is to provide (1) authorized patrons with articles and
services necessary for their health, comfort, and convenience and (2) DOD?s
morale, welfare, and recreation (MWR) programs with a source of funding. In
carrying out this dual mission, the exchanges operate retail stores, similar
to department stores, and provide a host of other services and specialty
stores, including furniture stores, florist shops, barber and beauty shops,
optical shops, liquor stores, and fast- food restaurants. For fiscal year
1999, the exchange services had over $9 billion in sales. For the past
several years, about 70 percent of the exchange services? profits from sales
were allocated to MWR activities and about 30 percent to new exchange
facilities and related capital projects.

Military exchange services? food operations generated about $734 million in
sales during fiscal year 1999, or about 8 percent of the exchanges? total
sales. The sales occurred at about 2,200 food outlets operated by three
military exchanges- the Army and Air Force Exchange Service (AAFES), the
Navy Exchange Service Command (NEXCOM), and the Marine Corps Community
Services (MCCS). 6 These outlets, located on military installations around
the world, included name- brand, fast- food restaurants, in- house signature
brand restaurants, and more generic food operations such as cafeterias and
snack bars. As shown by figure 1, over

6 AAFES and NEXCOM operate as separate nonappropriated fund entities.
Exchange operations that support the Marine Corps are combined with all MWR
activities and are managed by MCCS. Sales totals presented in the background
section of this report include restaurants managed by MCCS as well as the
other exchange services. Background

Page 6 GAO- 01- 683 Defense Management

50 percent of the $734 million in sales came from name- brand, fast- food
outlets.

Figure 1: Military Exchanges? Food Sales for Fiscal Year 1999

Source: GAO analysis of AAFES, NEXCOM, and MCCS financial data. Modern name-
brand, fast- food restaurants began to appear on military installations in
the early 1980s. In 1984, the Burger King Corporation and AAFES signed a 20-
year, master contract authorizing AAFES to construct and operate 185 Burger
King restaurants around the world. Each Burger King restaurant has a
separate contract consistent with the terms of the master contract. Also in
1984, NEXCOM awarded a 10- year, master contract to McDonald?s Corporation.
This contract, which was recompeted and renewed in 1994, allowed McDonald?s
to construct and operate restaurants at more than 40 locations around the
world. Both Burger King and McDonald?s contracts will expire in 2004.

Today, other national brands, such as Baskin Robbins, Kentucky Fried
Chicken, Pizza Hut, Popeye?s Chicken & Biscuits, Subway, Taco Bell, and
Wendy?s, can also be found on military installations. (See app. II for the
number of facilities and sales totals for AAFES and NEXCOM fast- food

Page 7 GAO- 01- 683 Defense Management

operations.) Fast- food restaurants are generally categorized by their
location, size, and/ or physical characteristics. A free- standing
restaurant is often referred to as a traditional or stand- alone restaurant-
it is located in a separate, distinct building with signage and logos that
clearly identify its brand. A restaurant located in a food court is often
referred to as a non- traditional or in- line restaurant. Free- standing
restaurants are usually larger in size and have higher sales volumes than
those found in food courts.

The Assistant Secretary of Defense (Force Management) is responsible for
establishing uniform policies for armed services exchange operations. 7 In
that capacity, the Assistant Secretary issued a policy memorandum for name-
brand, fast- food operations in January 1988. The policy memorandum, which
responded to recommendations from the House Committee on Armed Services, was
issued to control the proliferation of fast- food restaurants on military
installations and avoid a ?fast- food strip? effect, award business to
American investors, and ensure that name- brand, fast- food prices on
military installations in the United States were comparable to those in
communities adjacent to the military installation. The memorandum stated
that the policy would be strictly followed and any deviations had to be
approved in writing by the Assistant Secretary. However, the memorandum
provided no criteria for approving a deviation. In addition, the primary
armed services regulations governing MWR activities and the exchange
services give the secretaries of the military services a stake in
prescribing and overseeing the activities that can operate on their
facilities, including the method that will be used to operate fast- food
restaurants. 8

Our analysis of fiscal year 1998 and 1999 financial data showed that the
indirect method of operating name- brand, hamburger restaurants provided
greater profitability than the direct method. This was true regardless of
whether the restaurants were grouped and analyzed by sales volume,
restaurant type (stand- alone or part of a food court), or location
(continental United States or overseas). We also projected that if new

7 The Assistant Secretary reports to the Under Secretary (Personnel and
Readiness) who, in turn, reports to the Deputy Secretary of Defense. 8 DOD
Directive 1015. 1, Establishment, Management, and Control of Nonappropriated
Fund Instrumentalities, dated April 8, 1986, and DOD Directive 1330. 9,
Armed Services Exchange Regulation, dated December 15, 1986. The Indirect
Method

Has Been More Profitable for the Exchange Services

Page 8 GAO- 01- 683 Defense Management

name- brand, hamburger restaurants were to be built, the indirect method
would result in a higher return on investment over a 20- year period. In
conducting our analyses, we found that the exchange services had
appropriately considered the various types of costs of their fast- food
operations, except for overhead. We included overhead costs and the cost of
capital in our analyses.

For fiscal years 1998 and 1999, NEXCOM?s profits on 64 indirectly operated
hamburger restaurants were about 11.5 percent and 11.4 percent,
respectively, when measured as a percentage of total sales. Over the same
period, AAFES? profits on 164 and 171 directly operated hamburger
restaurants were 7. 8 and 5.5 percent, respectively. Table 1 provides the
results of our analysis.

Table 1: Fiscal Year 1998 and 1999 AAFES and NEXCOM Hamburger Restaurants?
Profitability (For the Periods Feb. 1, 1998 -

Jan. 31, 1999, and Feb. 1, 1999 - Jan. 31, 2000)

Dollars in thousands

Fiscal year 1998 Fiscal year 1999 AAFES? direct

method NEXCOM?s indirect method AAFES? direct

method NEXCOM?s indirect method

Total Percent of sales Total Percent

of sales Total Percent of sales Total Percent

of sales

Number of restaurants 164 64 171 64 Total sales $ 183,985 100.0 $ 66,392
100.0 $176,435 100.0 $ 67,430 100.0 Total revenues a 184,336 100.2 8, 006
12.1 b 176,632 100.1 8, 121 12.0 b Operating costs c 155,653 84.6 N/ A d N/
A d 152,555 86.5 N/ A d N/ A d Overhead costs 9, 015 4.9 359 0.5 9, 051 5.1
421 0.6 Net profit 19,668 10.7 7, 648 11.5 15,026 8. 5 7,700 11.4 Cost of
capital d 5,358 2.9 N/ A e N/ A e 5,354 3.0 N/ A e N/ A e Economic earnings
$ 14,310 7. 8 $ 7,648 11.5 $ 9,672 5. 5 $ 7,700 11.4

Note: Figures may not total due to rounding. a Revenues under the direct
method include restaurant sales plus other income, which is primarily the

proceeds from selling surplus equipment and additional revenue realized in
overseas locations from foreign currency conversions at the point of sale.
Revenues under the indirect method are commissions based on restaurant sales
plus licensing fees and signing bonuses. b An alternative way of expressing
NEXCOM?s profitability would be as a percentage of total revenues. Revenues
under the indirect method are not restaurant sales but are payments (sales
commissions, signing bonuses, and licensing fees) to an exchange service
from the name- brand, fast- food company based on restaurant sales. If
expressed as a percentage of revenues, NEXCOM?s profits would be 95.5 and
94.8 percent, respectively, for fiscal years 1998 and 1999. c Operating
costs include the cost of goods sold and depreciation.

Financial Analyses Show That the Indirect Method Provided Greater
Profitability

Page 9 GAO- 01- 683 Defense Management

d Cost of capital represents the opportunity cost (or economic cost)
associated with alternative uses for invested capital of comparable risk.
For AAFES, this would include funds invested in buildings and equipment
(including periodic renovations and upgrades) and inventory. AAFES used a
cost of capital of 10 percent for both fiscal years. We applied a cost of
capital charge to the average inventory value and the undepreciated value of
assets associated with AAFES? Burger King restaurants. e N/ A is being used
to note that, under the indirect method, NEXCOM does not have operating
costs

or a cost of capital. These costs are borne by the name- brand, fast- food
company or restaurant operator.

Source: Our analysis of AAFES and NEXCOM fiscal year 1998 and 1999 financial
data.

Although the table does not show major differences in results between fiscal
years 1998 and 1999, we have several observations about the profitability of
the two alternatives.

 For servicemember morale purposes, AAFES operates a number of unprofitable
Burger King restaurants in remote locations and overseas. In fiscal year
1999, for example, 56 of its 171 Burger King restaurants lost a combined
$2.7 million. Eliminating these 56 restaurants from our analysis showed that
the remaining 115 restaurants had profits of 9.2 percent of restaurant
sales- this compares more favorably with NEXCOM?s 11.4 percent for that
year.

 AAFES? overhead rates (4. 9 percent and 5.1 percent of sales) were
significantly higher than NEXCOM?s (0.5 percent and 0.6 percent of sales)
because of the different operating method. AAFES? overhead rates captured
the numerous support activities needed to manage the large infrastructure,
distribution network, and personnel associated with the exchange?s
operations. NEXCOM, on the other hand, had only a small number of support
personnel to oversee its contracts with McDonald?s.

 NEXCOM?s revenues under the indirect method were derived from one- time
signing bonuses, minimum guarantees, and annual licensing fees as well as
commissions on restaurant sales. Signing bonuses and licensing fees
accounted for approximately 25 percent of the revenues.

 Neither AAFES nor NEXCOM had established overhead rates for its restaurant
operations. Therefore, we used the AAFES exchangewide rates, which are the
rates AAFES applied to its overall operations for each of the 2 fiscal
years. In response to our review, NEXCOM computed overhead rates that showed
its limited support costs for overseeing its food service contracts.

 AAFES applied a 10- percent cost of capital to its restaurant operations,
which, when measured as a percentage of sales, was 2.9 and 3.0 percent,
respectively, for fiscal years 1998 and 1999. Because NEXCOM relies on
McDonald?s and its licensed operators to build and periodically renovate the
restaurant facilities, it had no capital costs.

Page 10 GAO- 01- 683 Defense Management

 AAFES? restaurant sales decreased about 4 percent between fiscal year 1998
and 1999 while its operating costs, as a percentage of sales, increased
about 2 percent. These changes did not appear to be related to the method
used to operate the restaurants.

 Both AAFES and NEXCOM rely on the military services for certain real
property maintenance activities, particularly for repairs to the exterior of
the restaurant building and the surrounding property. The exchanges,
however, did not show these costs, and they were not readily available from
the military services. In addition, both exchanges received similar support,
which would tend to mitigate the cost impact on relative profitability.
Therefore, we did not include them in our analysis.

As part of our analysis, we evaluated the profitability of both methods from
several perspectives- by sales volume, restaurant type (free- standing or
food court), and location (continental United States or overseas). Each
analysis showed that the indirect method was more profitable.

 Profitability by Sales Volume: We arrayed AAFES? directly operated and
NEXCOM?s indirectly operated restaurants by annual sales volumes. As shown
in table 2, the profitability of both types of restaurants improved as sales
volumes increased. However, NEXCOM?s profits measured as a percentage of
sales were higher than AAFES? in all categories for both fiscal years. For
some categories, such as sales over $500, 000 but less than $1 million, they
were more than twice as high. For example, in fiscal year 1998, AAFES?
restaurants had profits of 3.0 percent of sales while NEXCOM?s restaurants
had profits of 6.6 percent of sales. AAFES? profitability was negatively
affected by a large number of smaller restaurants that lost money in fiscal
years 1998 and 1999. In 1999, for example, 44 of its 97 restaurants with
sales under $1 million lost money. As table 2 shows, AAFES? restaurants with
sales of $500,000 or less lost 3.1 percent of sales and 1.7 percent of sales
for fiscal years 1998 and 1999, respectively. Indirect Method Was More

Profitable Under Various Scenarios

Page 11 GAO- 01- 683 Defense Management

Table 2: Profitability of Name- Brand, Hamburger Restaurants by Sales Volume
Fiscal year 1998 Fiscal year 1999

Sales volume AAFES? direct

method (profits expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

AAFES? direct method (profits

expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

$0 to $500,000 -3.1 a 2.4 5. 5 -1.7 a 2.4 4. 1 Over $500,000 to $1 million
3.0 6. 6 3.6 0. 9 6.8 5. 9 Over $1 million to $1.5 million 7.7 10.8 3. 1 6.6
11.5 4. 9 Over $1.5 million 10.9 15.0 4. 1 9.0 14.8 5. 8

a These percentages are preceded by a minus sign to indicate that AAFES?
restaurants in this sales volume category collectively lost money in both
1998 and 1999. Source: Our analysis of AAFES and NEXCOM financial data.

 Profitability by Restaurant Type: Both AAFES and NEXCOM operate
traditional or free- standing hamburger restaurants and smaller non-
traditional or food court type restaurants. As shown in table 3, free-
standing restaurants, which tend to have higher sales volumes, were more
profitable than restaurants located in a food court. NEXCOM?s average
profits, however, were higher in both fiscal years for each type of
restaurant.

Table 3: Profitability of Name- Brand, Hamburger Restaurants by Restaurant
Type Fiscal year 1998 Fiscal year 1999

Restaurant type AAFES? direct

method (profits expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

AAFES? direct method (profits

expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

Free standing 9. 1 12.4 3. 3 6.6 11.9 5. 3 Food court 2. 6 8.2 5. 6 2.0 9. 8
7.8

Source: Our analysis of AAFES and NEXCOM financial data.

 Profitability by Location: About 60 percent of AAFES? restaurants and 80
percent of NEXCOM?s restaurants are located within the continental United
States. As shown in table 4, NEXCOM?s indirectly operated restaurants were
more profitable, regardless of their location. The biggest difference in
profitability, however, was in restaurants located outside the continental
United States. In fiscal year 1999, for example, the 69 overseas restaurants
operated directly by AAFES had profits that averaged about 2 percent of
sales, or $21,000 per restaurant. Almost half of its overseas restaurants,
which were located in various

Page 12 GAO- 01- 683 Defense Management

countries around the world, lost money in 1999. On the other hand, NEXCOM?s
12 overseas restaurants had average profits of about 14 percent of sales, or
about $224,000 per restaurant.

Table 4: Profitability of Name- Brand, Hamburger Restaurants by Location
Fiscal year 1998 Fiscal year 1999

Location of restaurant

AAFES? direct method (profits

expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

AAFES? direct method (profits

expressed as percent of sales)

NEXCOM?s indirect method (profits

expressed as percent of sales) Difference

United States 9.3 10.2 0. 9 7.9 10.4 2. 5 Overseas 5.6 15.3 9. 7 2.0 14.0
12.0

Source: Our analysis of AAFES and NEXCOM financial data.

In addition to our profitability analysis of fiscal year 1998 and 1999
financial data, we performed a 20- year, cash flow analysis for a capital
investment in a new name- brand, hamburger restaurant. This analysis showed
that the indirect method would produce about twice the net cash flow, in
current- year dollars, as the direct method. A recent Army consultant?s
study reached a similar conclusion.

A cash flow analysis is a technique that is sometimes used at the beginning
of a project to assess investment alternatives or strategies. Net present
value techniques can show, in today?s dollars, the relative net cash flow of
various alternatives over a long period of time- in the case of our study,
20 years. Simply stated, net cash flow is the amount of dollars that is left
after sales or revenues have offset expenses. In general, the greater the
net cash flow for a particular investment, the greater the return on the
investment. In conducting this analysis, we combined the fiscal year 1998
and 1999 data for both AAFES and NEXCOM and calculated average annual sales,
net profit, and depreciation per restaurant for free- standing and food
court restaurants. In conducting our analysis, we assumed that the financial
data would remain constant over the 20- year period. We also made a number
of assumptions about factors such as the frequency of renovations (which
require incremental capital investments), inflation rates, and the exchange
services? cost of capital. Using the data and applying the assumptions, we
discounted the restaurants? projected cash flows for a 20- year period. The
methodology we used for the analysis is discussed more thoroughly in
appendix I.

As indicated in table 5, our analysis shows that over a 20- year period the
direct method has a significantly lower net cash flow, in today?s dollars,
Investment Analysis

Projected That the Indirect Method Would Provide a Greater Return on
Investment if New Restaurants Were Built

Page 13 GAO- 01- 683 Defense Management

for both free- standing and food court restaurants than the indirect method.
This is due primarily to the significant initial investment, shown as
$1,025,000 for the free- standing restaurant and $375,000 for the food court
restaurant, required to build and equip the facilities and the subsequent
periodic capital improvements that are required about every 5 years by
AAFES? contract with Burger King. We also performed a number of other cash
flow analyses using alternative assumptions (see app. I). While the bottom-
line numbers changed somewhat, the overall results were generally the same.

Table 5: 20- Year Net Present Value of Discounted Cash Flows for the Direct
and Indirect Methods - Free- standing and Food Court Name- Brand, Hamburger
Restaurants (Fiscal Years 1998 and 1999)

Free- standing restaurants Food court restaurants AAFES operated under
direct method NEXCOM operated

under indirect method AAFES operated under direct method NEXCOM operated

under indirect method Financial information:

Sales per restaurant $ 1,348,598 $ 1,282,381 $ 634,845 $ 637,216 Net profit
per restaurant 146,054 156,109 34,849 57,510 Depreciation per restaurant a
52,058 N/ A 37,654 N/ A

Capital requirements:

Initial facility, equipment, and fixtures

$ 1,025,000 N/ A $ 375,000 N/ A Incremental capital investment applied in
years 5, 10, and 15

100,000 N/ A 25,000 N/ A

Economic assumptions:

Real cost of capital b 7.5% N/ A 7. 5% N/ A

Discounted cash flows:

Year 0 $ -1,025,000 0 $ -375, 000 0 Year 1- 4 663,543 $ 522,861 242,836 $
192,618 Year 5 68,341 108,739 33,089 40,059 Year 6- 9 462,196 364,203
169,150 134,170 Year 10 47,603 75,743 23,048 27,903 Year 11- 14 321,947
253,689 117,823 93,457 Year 15 33,159 52,760 16,054 19,436 Year 16- 20
270,893 213,459 99,139 78,637

Net present value of cash flows

$ 842, 682 $ 1,591,454 $ 326,138 $ 586,280 a Annual depreciation expense was
added to annual net profit to determine the annual cash flow. Although
depreciation is an expense that reduces net profit, it does not involve cash
payments. Therefore, we included depreciation in the calculation of cash
flows for the direct method.

Page 14 GAO- 01- 683 Defense Management

b Because the current projection of future inflation is about 2. 5 percent,
we subtracted this rate from AAFES? 10 percent nominal cost of capital rate
to arrive at a real cost of capital rate of 7.5 percent. We also conducted
this analysis using cost of capital rates of 7 percent and 8 percent to
determine if changes in the rate would affect the outcome of the analysis.
Under these scenarios, the indirect method still produced higher net cash
flows, in today?s dollars, than the direct method.

Source: Our analysis of AAFES and NEXCOM financial data.

The Army, which plans to open name- brand, fast- food restaurants at some of
its MWR activities, sponsored a study in April 2000 to determine which
method- direct or indirect- would provide the greatest returns on its
investment. This study, which was conducted by a consulting firm in the food
and hospitality industry, used the net present value technique to project
cash flows for five different name- brand food types- hamburgers, chicken,
pizza, Mexican, and sandwiches. The study was based on sales, cost,
overhead, and profit data from AAFES, NEXCOM, and industry sources. It
applied the data to a 10- year investment period and concluded that the
indirect method provided more cash flows for both free- standing and food
court hamburger restaurants and generally was the best value for the Army?s
MWR activities.

Our analysis of AAFES and NEXCOM financial data showed that the exchanges
had, with only one exception, considered the various types of costs
associated with their fast- food operations. The one exception was overhead.
Neither AAFES nor NEXCOM used overhead costs when determining the profits
associated with its individual restaurants.

At AAFES, we found that it did not include overhead costs when reporting
profits from fast- food operations. Instead, it calculated and applied an
exchangewide overhead rate to its total operations to determine exchangewide
profits. In doing this, AAFES accumulated its general and administrative
costs from local exchanges and regional and headquarters operations. Its
overhead rates were 4.9 percent of sales and 5.1 percent of sales for fiscal
years 1998 and 1999, respectively. We compared the rates with overhead rates
of fast- food restaurants in the private sector and found that the AAFES
rates were reasonable. We also reviewed the work completed by AAFES?
internal auditors that related to reviewing the exchangewide overhead rates.
We concluded that the methodology used by the internal auditors to review
the rates was reasonable. Before using the exchangewide rates for our
analysis, however, we asked AAFES food service and financial management
officials if they had an overhead rate for just fast- food operations. They
responded in writing, as well as in several follow- up discussions on this
topic, that they did not have such a rate. They told us that previous
efforts to develop one had proved too difficult because of the way costs
were accumulated and accounted for. Except for Overhead,

Exchanges Considered the Various Types of Costs When Assessing Fast- food
Operations

Page 15 GAO- 01- 683 Defense Management

Accordingly, we used the 4.9 percent and 5.1 percent rates in our analysis
of 1998 and 1999 financial data.

However, after completing our work at AAFES, representatives of AAFES
informed us they had developed overhead rates specifically for namebrand,
hamburger restaurants operating under the direct method. The rates were 3.3
percent for both fiscal years 1998 and 1999. We discussed the approach AAFES
used to develop these new rates but were unable to readily assess their
accuracy because the information AAFES provided was not sufficient to
support the differences in overhead costs between food service direct
operations and exchangewide operations. We assessed the reasonableness of
the new rates by comparing them with the rates of eight food service
companies. All of the companies were included in

Fortune Magazine?s list of top 10 food service companies based on revenues.
This comparison showed that the new rates were substantially lower than
those used by the food service companies included in our analysis. Based on
the results of this comparison, we did not use the new rates in our detailed
analysis shown in table 1. However, if we had used the revised rates, the
profitability of the direct method would remain less than the indirect
method, but the differences would not be as great.

At NEXCOM, we found that it had not considered overhead costs when assessing
the financial results of its fast- food operations. As a result of our work,
the exchange developed overhead rates for its indirect fast- food
operations. The rates developed were 0.5 percent and 0.6 percent of the
franchisees? sales for fiscal years 1998 and 1999, respectively. We used
these rates in our analyses. Before using the rates, however, we reviewed
the methodology NEXCOM used to develop them. We found that the methodology
and costs included in the overhead rates appeared reasonable. When compared
to AAFES? overhead rates, NEXCOM?s rates appeared small. This condition
exists because the indirect method requires significantly fewer people to
manage and oversee fast- food operations. For example, to support such
operations, NEXCOM had to negotiate and oversee several contracts, while
AAFES had to manage all of the operations of about 170 restaurants.

Page 16 GAO- 01- 683 Defense Management

Exchange officials identified a number of factors, other than profitability,
that are important when deciding between the direct and indirect methods. As
shown in table 6, we grouped these factors into six categories: financial
risk, customer service, employment opportunities, management control,
operational risk, and investment opportunities. The relative importance of
individual factors might vary depending on the circumstances involved in
selecting an operating method for a planned restaurant. However, neither
exchange used a standard approach or methodology to determine their relative
importance or to evaluate them along with profitability considerations.

Table 6: Factors That Benefit the Direct and Indirect Methods Benefits
applicable to Benefits Direct

method Indirect method

Financial risk

Minimizes capital investment for buildings, equipment, and fixtures X May
provide revenues, at least in the short term, if restaurant does not make a
profit X

Customer service

Serves equivalent American menus at or below local market prices worldwide X
X Serves equivalent American products worldwide X Provides name- brand food
to remote locations that may not be profitable X Provides name- brand food
service overseas X X Customers are not charged sales tax X

Employment opportunities

Provides job opportunities to members and family X X Provides employment
preference to family members X Provides portable employment benefits X

Management control

Minimizes the size of the management infrastructure X Provides direct
control over customer service issues X Can respond quickly to support
deployment requirements X Can change hours of operation to meet military
needs X Provides a single point of contact worldwide to address issues and
implement changes X Reduces construction/ renovation cycle time X

Operational risk

Potentially reduces liability for losses and claims X Minimizes the risk to
profits due to poor performance X

Investment opportunities

Minimizes competition with the private sector X Supports DOD?s policy to
assess opportunities for public- private ventures X

Source: Our analysis of information provided by AAFES and NEXCOM.

Factors Other Than Profitability Are Important When Choosing an Operating
Method

Page 17 GAO- 01- 683 Defense Management

 Indirect Method Minimizes Financial Risk: Under the indirect method, the
name- brand, fast- food company builds the restaurants and assumes the
financial risk of recovering its capital investments and operating at a
profit. The exchange service, in this situation, has no capital investment
and generally receives a commission on restaurant sales, regardless of
whether the restaurant makes a profit. Under the direct method, the opposite
is true. The exchange service provides the capital for building and
periodically updating the restaurant, assumes all financial risks of
operations, and generally pays the name- brand company an annual licensing
fee and a royalty or commission on its annual sales.

 Both Methods Provide Customer Service: Both methods can be used
domestically and overseas and require the exchange services to offer menus
and prices equivalent to those in the private sector. 9 Under the direct
method, however, an exchange service can establish restaurants in less
profitable, remote locations in order to boost military members? morale. For
example, AAFES officials told us that soon after the military was deployed
to Bosnia for the peacekeeping mission, it opened three hamburger
restaurants. It also opened 14 food service outlets in the Balkans and
Kosovo, including 4 hamburger restaurants, and it has responded to many
other emergencies or humanitarian deployments over the years. AAFES believes
this would not have been possible under the indirect method because it did
not believe namebrand companies would have been willing to operate in such
potentially dangerous or unprofitable locations. In fact, NEXCOM officials
provided us information showing that several restaurants operating under the
indirect method at Navy installations had been closed during the last
several years due to low sales. Nevertheless, NEXCOM officials believe the
indirect method of operation adequately meets the deployment needs of the
Navy, which are fundamentally different than those of the Air Force and the
Army. Moreover, NEXCOM officials believe some of the name- brand companies
that support its indirect operations are capable of providing emergency
service as well as service to remote locations around the world. Another
advantage of the direct method is that customers do not have

9 AAFES officials agreed that both methods offer equivalent menus worldwide.
However, they noted that product consistency, such as the taste of
hamburgers, may vary under the indirect method because concessionaires may
have to use local sources of supply rather than a single supplier. AAFES, on
the other hand, is the major supplier for its restaurants and contends that
it can provide a more consistent product overseas.

Page 18 GAO- 01- 683 Defense Management

to pay sales tax. This advantage provides varying degrees of savings to the
customer, depending on the state and local taxes applicable at each
location.

 Direct Method Provides Greater Employment Opportunities for Military
Dependents: Both methods provide employment opportunities for military
dependents. However, because AAFES has control over the hiring practices at
its directly run restaurants, it gives military spouses and other family
members employment preferences. According to AAFES, about half of its work
force are military dependents, some of which have worked for years with
AAFES as they have moved from one installation to another. These employees
retain their benefits (medical, sick leave, etc.) when they move as long as
they continue to work for AAFES.

 Direct Method Provides More Control Over Operations: Under the direct
method, the exchange services have more control over operations. AAFES
officials said that this control gives them the ability to (1) establish
restaurant hours that best support military needs, (2) address customer
service issues consistently throughout the AAFES restaurant network, and (3)
support the Army and Air Force mission objectives, which involve deploying
personnel in war zones or other remote areas throughout the world. With its
large supply and distribution network and access to resources, it can
respond quickly to emergency situations almost anywhere in the world. On the
other hand, the indirect method requires practically no infrastructure
because the name- brand company and/ or its restaurant operator handles all
construction and operating issues. NEXCOM personnel agreed that the indirect
method gave the exchange limited operating control of its restaurants but
did not think such control was necessary because it does not provide fast-
food operations on ships. Instead, most of its restaurants are located at
large seaports or bases in the United States and overseas and generally
operate in a normal commercial environment.

 Indirect Method Limits Operational Risks: Under the indirect method, the
food service company and its restaurant operators are responsible for
achieving sales goals, procuring and managing product inventories,
maintaining the physical plant and equipment, developing promotions and
marketing strategies, planning and updating menus, managing the food
preparation process (including controlling the size of food portions),
hiring and training all personnel, and assuming losses associated with
breakdowns in internal controls. In addition, restaurant

Page 19 GAO- 01- 683 Defense Management

operators assume the primary risk for workers? compensation claims and
litigation associated with such things as accidents, harm caused by
products, and employee injuries. Under the direct method, these issues fall
primarily with the exchange service.

 Indirect Method Promotes Private Sector Investment Opportunities: The
indirect method provides investment opportunities for private sector
citizens, who are likely to be members of the local business community, and
reduces concerns about government encroachment into private- sector
functions, one of the objectives of DOD?s 1988 fastfood policy. AAFES
officials told us that requests to build name- brand, fast- food restaurants
on a military installation have sometimes been denied because an existing
franchise restaurant would have been adversely affected. The indirect method
is also consistent with DOD?s more recent 1998 policy to consider public-
private ventures as an alternative for enhancing business activities that
support MWR programs. 10 This policy, which involves the indirect method of
operation, calls for the exchange services to consider public- private
ventures as an alternative source to meet capital requirements that exceed
$1 million.

NEXCOM and AAFES officials told us that they need flexibility to determine
how best to meet their mission objectives and satisfy the military services?
needs. Therefore, they are opposed to the adoption of a single method of
operating name- brand, fast- food restaurants. Even NEXCOM officials, who
use the indirect method to operate most of the exchange?s fast- food
restaurants, said situations exist where the direct method makes more sense.
Neither exchange, however, used a business case analysis that weighed the
factors identified in table 6 with profitability considerations, which then
led to a decision to choose a particular operating method.

10 DOD policy for public- private ventures is in Instruction 1015. 13,
Department of Defense Procedures for Implementing Public- Private Ventures
(PPVs) for Morale, Welfare, and Recreation (MWR) Category C Revenue-
Generating Activities, dated June 17, 1998.

Page 20 GAO- 01- 683 Defense Management

DOD?s policy on operating name- brand, fast- food restaurants established a
preference for using the indirect method within the continental United
States and the direct method overseas. The exchanges, however, have not
always followed this policy because, in part, DOD has not provided guidance
for evaluating operating methods or criteria for determining when a
deviation from the policy might be justified. In general, each exchange
service has adopted the operating method that it believes best fits its
particular circumstances. While the exchanges may need flexibility to choose
an operating method that best meets their mission requirements, DOD may be
missing opportunities to reduce the exchanges? operating risks and increase
the amount of funds provided to MWR activities because DOD?s policy is not
clear and department officials have provided limited management oversight.

In early 1988, when DOD issued its current policy memorandum on namebrand,
fast- food operations, its stated goals were to control the proliferation of
fast- food restaurants on military installations, award business to American
investors, and ensure that restaurants on military installations charged
prices that were comparable to those in adjacent communities. To help
achieve these goals, the policy expressed a

?preference? for using the indirect method within the continental United
States and the direct method overseas. 11 The policy also stated that the
requirements would be strictly followed and any deviations had to be
approved in writing by the Assistant Secretary (Force Management). However,
the policy memorandum provided no criteria for approving a deviation. The
policy memorandum also stated that construction of fast- food restaurants
would continue to be reviewed as part of the annual nonappropriated fund
construction program.

Officials in the Office of the Assistant Secretary told us that the policy
is still the primary guidance for determining how name- brand, fast- food
restaurants should be operated. They acknowledged that the policy lacks
criteria for determining when a deviation from the policy should be
approved. They also stated that, for the most part, they have not been
actively involved in overseeing how well the exchanges were adhering to the
policy. They pointed out, however, that, in June 1998, the Department issued
a new instruction that bears on this issue. This instruction calls for

11 DOD?s policy objectives generally relate to U. S. restaurants. Although
the policy did not state a rationale for preferring the direct method
overseas, DOD officials told us that there was a recognition that relying on
the private sector to provide fast- food services in other countries might
not be a viable alternative. DOD?s Policy Lacks

Guidance for Evaluating Operating Methods and Criteria for Approving
Deviations From the Policy

Page 21 GAO- 01- 683 Defense Management

the military secretaries and exchange services to consider public- private
ventures as an alternative way of meeting capital requirements when the
requirement exceeds $1 million. Each public- private venture is to be
supported by an economic analysis. In addition, whenever a venture involves
construction financed by the private sector, an overseas fast- food
restaurant, or liabilities to the government in excess of $500,000, it is to
be reviewed by DOD policy officials. These officials pointed out that they
have taken a more active role in overseeing compliance with the instruction.
Thus far, however, the instruction has had minimal application to the
exchange services? restaurant operations since contracts for most of these
restaurants existed before the instruction was issued. DOD policy officials?
recent reviews have applied, for the most part, to public- private ventures
associated with the military services? MWR activities, rather than the
military exchanges. Consequently, it is somewhat unclear if and how the
instruction will affect the Department?s long- standing name- brand, fast-
food policy.

Since name- brand, fast- food restaurants first appeared on military
installations in the 1980s, each exchange has tended to adopt an operating
method that it believes best fits its overall mission objectives, operating
philosophies, and access to capital resources. AAFES, for example, has a
large support infrastructure, access to investment capital, and a long
history of directly operating the majority of its business operations. It
seldom deviates from the direct method, either within the United States or
overseas. 12 While this approach appears to be in conflict with DOD?s
preference for using the indirect method in the continental United States,
AAFES officials believe they are following DOD policy and congressional
guidance. In explaining this situation, they noted that both DOD and the
Congress had annually approved construction projects for directly operated
restaurants in the United States. This was, in their view, an indication
that AAFES had the flexibility and approval to deviate from the policy
without asking for a formal waiver. NEXCOM, on the other hand, does not have
a large support infrastructure and prefers not to invest capital in such
restaurants. It has, therefore, adopted the indirect method of operating its
restaurants, even in overseas locations.

12 AAFES uses the indirect method to operate several name- brand restaurants
in the United States, including three McDonald?s restaurants. AAFES
officials told us the indirect method was selected in these situations to
address private sector concerns about AAFES building and operating
restaurants that would compete with or encroach on the business of existing
restaurants in nearby communities.

Page 22 GAO- 01- 683 Defense Management

While exchange personnel told us that they generally prepared an analysis
prior to building a new restaurant, the analysis focused primarily on what
type and/ or size of restaurant would best meet an installation?s
requirements (free- standing or food court) and whether it would be
profitable under the specific circumstances. It did not include an analysis
of the relative benefits- including profitability and other factors such as
those discussed in this report- of the direct and indirect methods of
operating the restaurant. As a result, the exchanges are not conducting the
type of business case analysis that we believe would help them select and
justify the operating method that best balances restaurant profitability
with other factors.

The Department may have missed opportunities to increase profits for MWR
activities because its policy for operating name- brand, fast- food
restaurants has not been clear and policy implementation has not been
subject to consistent management oversight. As a result, the exchange
services have not always had a compelling reason to analyze the financial
and operational benefits of the two operating methods. While our analyses
clearly showed that the indirect method produced greater profitability in
the recent past and has the potential to generate higher profits if new
restaurants are built, other factors can be important when deciding on which
method to use. Nevertheless, the exchanges do not systematically develop a
business case analysis to justify an operating method- an analysis that
considers profitability and other factors before deciding which operating
method to use. To address this situation, DOD needs a clear policy- one that
includes a standard approach or methodology for selecting a name- brand
restaurant?s operating method. A rigorous financial analysis and
consideration of other factors would be part of the methodology. In
addition, the policy needs to specify criteria that will help DOD evaluate
when deviations from any preferred method are justified. Finally, the policy
needs to address how the Department?s new instruction on public- private
ventures bears on its fast- food policy. Having a sound name- brand, fast-
food policy is likely to become increasingly important to DOD because the
exchange services? contracts with major name- brand companies will expire in
2004 and the exchanges will have to decide which method will be used to
continue providing name- brand fast food.

To properly weigh profitability and other factors in selecting operating
approaches for name- brand, fast- food operations on military installations,
we are recommending that the Under Secretary of Defense (Personnel and
Readiness), in conjunction with the secretaries of the military services,
revise the Department?s name- brand, fast- food policy by Conclusion

Recommendation for Executive Action

Page 23 GAO- 01- 683 Defense Management

 incorporating a standard methodology that considers both profitability and
other factors to be used by the exchange services to identify the most
appropriate method for operating fast- food restaurants,

 including criteria to approve deviations from any preferred operating
method specified in the revised policy guidance, and

 clarifying how the instruction on public- private ventures affects the
policy.

We also recommend that the exchange service commanders ensure that the
standard methodology is used before they renew a restaurant contract or open
a new restaurant.

In commenting on a draft of this report, the Assistant Secretary of Defense
(Force Management Policy) concurred with its conclusions and
recommendations. The Assistant Secretary stated that the Department will
revise its name- brand, fast- food policy by (1) including a methodology
that evaluates both economic and noneconomic factors when selecting an
operating method, (2) including criteria and procedures for approving
waivers from using the preferred operating method, and (3) clarifying how
its instruction on public- private ventures applies to its policy. DOD
expects to issue updated policy by November 1, 2001. DOD?s comments are in
appendix III.

We are sending copies of this report to the Secretary of Defense; the Under
Secretary of Defense (Personnel and Readiness); the Secretaries of the Air
Force, the Army, and the Navy; the Commander, AAFES; the Commander, NEXCOM;
the Director, Office of Management and Budget; and interested Agency
Comments

Page 24 GAO- 01- 683 Defense Management

congressional committees and members. We will also make copies available to
others upon request.

If you or your staff have questions concerning this letter, please contact
us on (202) 512- 8412. Staff acknowledgments are listed in appendix IV.

Barry W. Holman, Director Defense Capabilities and Management

Gregory D. Kutz, Director Financial Management and Assurance

Appendix I: Scope and Methodology Page 25 GAO- 01- 683 Defense Management

To develop an understanding of the military exchanges? name- brand, fast-
food operations, we reviewed the history of these operations in the
Department of Defense (DOD). We met with management officials from the
Office of the Under Secretary of Defense (Personnel and Readiness)
responsible for DOD?s name- brand, fast- food policy and discussed the
Department?s implementation of its policy. We also met with senior
management officials from the Army and the Air Force responsible for food
services that supported morale, welfare, and recreation (MWR) activities to
obtain their views on the direct and indirect methods of operating fast-
food restaurants. We reviewed applicable DOD policies and regulations,
related policy memorandums, and reports related to exchange service fast-
food operations. We met with senior executives and managers responsible for
financial management and food services at the Army and Air Force Exchange
Service (AAFES) and the Navy Exchange Service Command (NEXCOM) headquarters
to discuss fast- food operations and review documentation, financial
reports, internal and external audit reports, and contract data.

To determine which method of operating name- brand, fast- food restaurants
was more profitable, we obtained and analyzed detailed financial information
from AAFES and NEXCOM for their fiscal year 1998 and 1999 name- brand,
hamburger sales; associated costs and expenses; commissions; and related
data. The financial data for these years was the most current data available
at the time of our review. The data involved primarily Burger King
restaurants operated by AAFES and McDonald?s restaurants operated by either
McDonald?s Corporation or its licensed operators (also called
concessionaires) under NEXCOM?s purview. Because hamburger sales represented
over 50 percent of the exchanges? name- brand, fast- food sales for these
years, we primarily analyzed hamburger restaurants, which represented the
largest segment of name- brand, fast- food sales and therefore provided a
sound basis for comparing the direct and indirect methods of operation.

We analyzed the overall profitability of the restaurants operated under each
method. For the direct method, net profit represented a restaurant?s total
revenues less its operating costs and overhead costs. Economic earnings
represented net profit less the opportunity cost associated with invested
capital- this is also known as the cost of capital. For the indirect method,
net profit and economic earnings represented the revenues- comprised of
sales commissions, signing bonuses, and licensing fees- received from the
name- brand company less overhead costs. Operating costs and the cost of
capital were not applicable to the indirect method. Besides assessing
overall profitability, we also analyzed profitability by Appendix I: Scope
and Methodology

Appendix I: Scope and Methodology Page 26 GAO- 01- 683 Defense Management

sales volume, restaurant type (free- standing and food court), and general
location (continental United States or overseas) to isolate unique
conditions that might exist under one of the methods of operation. In this
report, our use of the terms ?profit? or ?profitability? refers to economic
earnings for the direct method of operation and net profit for the indirect
method of operation, which are expressed as a percentage of restaurant
sales.

To determine if the exchange services considered all of the costs of their
name- brand, fast- food operations, we reviewed financial reports, general
ledger balances, and other data provided to us by each exchange service.
However, we did not verify the accuracy and reliability of the data
submitted to us by AAFES and NEXCOM management and express no opinion on its
reliability. Both exchanges are audited annually by independent public
accountants. For the fiscal years we reviewed (1998 and 1999), NEXCOM
received an unqualified opinion and AAFES received an ?except for? qualified
opinion on their financial statements. 1 We read the audit opinions for each
exchange service to determine if there were any material weaknesses that
came to the auditors? attention that would indicate the financial data were
unreliable. Except for AAFES not recording the cost of a defined benefit
pension plan in accordance with Statement on Financial Accounting Standard
No. 87, Employer?s Accounting for Pensions, material weaknesses were not
reported by the exchange services? independent public accountants. We
discussed this issue with AAFES management and concluded that it did not
have a bearing on the financial data we used in our analysis.

To determine the reasonableness of the exchanges? overhead rates, we
reviewed the methodologies the exchange services used to capture and
allocate overhead costs. We met with management and internal audit
representatives of each exchange service to review steps they had taken to
validate the methodologies and costs included in the overhead rates. We also
compared the exchange services? overhead rates to rates reported by leading
name- brand, food service companies in their annual financial reports.
NEXCOM developed its overhead rate after we inquired about overhead costs
related to name- brand fast foods. AAFES had corporatewide overhead rates of
4.9 and 5. 1 percent of sales for 1998 and

1 In general, the fiscal year for the exchange services covers the period
from February 1st of a given year to January 31st of the following year.
This period is consistent with the fiscal year used by the retail industry.

Appendix I: Scope and Methodology Page 27 GAO- 01- 683 Defense Management

1999, respectively, which we used in our financial analysis. Before using
them, however, we met with AAFES financial management and food service
officials to determine if the exchange service had or could develop a rate
for food operations in general or for restaurants operating under the direct
method. AAFES officials told us they were unable to develop an overhead rate
for food operations. Subsequent to completing our work at AAFES,
representatives of AAFES informed us they had developed new overhead rates
specifically for name- brand, hamburger restaurants operating under the
direct method. The rates were 3.3 percent for both fiscal years 1998 and
1999. We discussed the approach AAFES used to develop these rates. We also
compared AAFES? new overhead rates with the rates of eight food service
companies that included a range of name- brand companies. All of the
companies were included in Fortune Magazine?s list of top 10 food service
companies based on revenues. We obtained these food service companies?
overhead rates from their published financial statements. This comparison
showed that AAFES? new rates of 3.3 percent were substantially lower than
those used by the food service companies included in our analysis. Rates for
these companies ranged from 3.8 percent to 11.8 percent, with the mid- range
rate being about 6.3 percent. Based on the results of this comparison, we
did not use AAFES? new rates in our detailed analysis shown in table 1.
However, if we had used the new rates, AAFES? profitability as a percentage
of sales would increase from 7.8 percent to 9.4 percent in fiscal year 1998,
and from 5.5 percent to 7.3 percent in fiscal year 1999 - still less
profitable than the indirect method.

The cost of capital applies to AAFES because, under the direct method, it
builds and equips its restaurants. When making a decision to build and
operate a restaurant, an exchange needs to evaluate the costs of initial
construction, initial equipment and fixtures, and subsequent scheduled
renovations (to the extent they are known). These costs, generally referred
to as capital costs, are usually paid for by AAFES through borrowing or
through cash that is available from its profits. Also, other potential uses
of the capital should be considered in the evaluation to ensure that
committing capital to building the restaurant is a sound and defensible
financial decision. These costs may include implicit costs, such as
opportunity costs, that would not appear on an entity?s financial statements
but should be considered when evaluating profitability and making capital
investment decisions. The ability of a restaurant to recover these costs
will depend on the expected profitability of the restaurant as well as
financial and operational risks associated with the restaurant?s operations.
Some companies and organizations, such as AAFES, establish

Appendix I: Scope and Methodology Page 28 GAO- 01- 683 Defense Management

a cost of capital rate, normally expressed as a percentage, to evaluate
their existing and planned capital projects.

AAFES used a 10- percent cost of capital during both fiscal years 1998 and
1999 and applied this rate to capital investment decisions. In other words,
AAFES expects to earn at least 10 percent on its capital investments. With
respect to assessing profits from its fast- food operations, AAFES also
applied this rate to the average cost of its supply inventories and the
undepreciated value (net book value) of its buildings, equipment, and
subsequent improvements and replacements. In our profitability analysis, we
applied a cost of capital charge to net profits to determine economic
earnings. Our method of calculating the cost of capital charge was
consistent with the method AAFES used.

To test the reasonableness of AAFES? 10- percent cost of capital rate, we
calculated a cost of capital number that could apply to a private sector
company in the food services industry. We used a standard approach, a
weighted average cost of capital, found in corporate finance text books to
calculate a cost of capital that would be appropriate for firms in the name-
brand, hamburger industry. We also used financial data from Value Line
Publishing for two major food service corporations, McDonald?s and Wendy?s,
to make our calculation. 2 Because the financial situation of every business
entity will be different, we did not expect our calculation to produce the
same rate that AAFES used, but we did want to assure ourselves that AAFES?
reported cost of capital was reasonable for firms in the fast- food,
hamburger business. The cost of capital rate we calculated was close enough
to AAFES? to assure ourselves that it was appropriate to use it in our
calculation.

We also conducted a 20- year, net present value analysis of future cash
flows for a capital investment in a new name- brand, fast- food hamburger
restaurant for both methods. Our analysis was based on fiscal year 1998 and
1999 sales and cost data provided by the exchange services. We applied an
investment planning tool, called net present value, which measures both the
magnitude and timing of projected cash flows and discounts the expected
annual cash flows by applying the time value of money to reflect their value
today. As a result, the analysis shows, in today?s dollars, the financial
return that an investment in such a restaurant

2 We did not use financial data for Burger King because a European firm
whose primary business is wine and spirits owns Burger King.

Appendix I: Scope and Methodology Page 29 GAO- 01- 683 Defense Management

operated under each method is expected to contribute to an exchange
service?s profits. We chose 20 years because this is generally the useful
life of the facilities and equipment. We calculated a per restaurant average
for sales and cost of operations. For the direct method, we added
depreciation expenses to net profit to arrive at the annual positive cash
flow. We included depreciation in the cash flow because, although it is an
expense that is considered in arriving at net income, it does not represent
an outlay of cash. The net present value technique also calls for
depreciation to be included in the cash flows. We used initial construction
and equipment costs provided by AAFES. The required incremental capital
investments were based on historical data also provided to us by AAFES.

We conducted several analyses using the net present value technique. First,
we combined the fiscal year 1998 and 1999 sales data obtained from each
exchange service and calculated per restaurant average sales over the 2-
year period. This analysis is presented in the body of the report. We also
conducted several other analyses. They included analyses of (1) fiscal year
1998 data, (2) fiscal year 1999 data, and (3) a pro forma analysis that used
equivalent sales for each exchange. The pro forma analysis was intended to
neutralize the difference in sales volumes of AAFES and NEXCOM.

Our analysis was also based on a number of assumptions. For example, we
assumed that combining or averaging 1998 and 1999 financial data would be
representative of sales and costs for each year in the 20- year period. We
also used a facilities and equipment renovation cycle of every 5 years,
which is consistent with the information provided by AAFES and NEXCOM. For
each method, we analyzed free- standing and food court restaurants
separately because of significant differences in their capital costs, sales
volumes, and cash flows.

The discount rate we used to calculate the net present value figures was
based on AAFES? cost of capital, which was 10 percent. We needed to use a
real cost of capital so we adjusted AFFES? cost of capital by subtracting
projected future inflation to derive a real cost of capital. We used the
March 2001 Blue Chip Economic Indicators, which are averages of the
projections of many major economic forecasters, to derive a long- term
inflation forecast of the Consumer Price Index (for all urban consumers).
The long- range forecast was about 2.5 percent. The Congressional Budget
Office and the Office of Management and Budget were also forecasting around
2.5 percent in their latest long- range projections for this price index. We
subtracted the long- term inflation forecast of 2.5 percent from

Appendix I: Scope and Methodology Page 30 GAO- 01- 683 Defense Management

AFFES? 10 percent cost of capital to derive a real cost of capital of 7.5
percent, which we used in our cash flow analysis.

We also did a sensitivity analysis for the inflation forecast with two other
scenarios to see if this would change our results. We assumed the inflation
rate could be as low as 2 percent and as high as 3 percent, which would
change the real cost of capital to 8 percent and 7 percent, respectively.
Under these two scenarios, our conclusions did not change. We also projected
the results beyond 20 years to determine when AAFES? total net cash flows
for a new name- brand, hamburger restaurant would break- even with and begin
to exceed NEXCOM?s. We knew this might eventually happen because AAFES?
annual net cash flows exceeded NEXCOM?s, except in the years that involved
additional capital investment for required renovations. This analysis showed
that, before the annual net cash flows were discounted, AAFES? cash flows
would not begin to exceed NEXCOM?s until after the 35th year of operation
for a food court restaurant and after the 80th year for a free- standing
restaurant. If the cash flows were discounted, it would take longer for
AAFES? net cash flows to exceed NEXCOM?s.

To determine if a single method of operating name- brand, fast- food
restaurants would be more beneficial to DOD when factors other than
profitability were considered, we obtained documentation related to this
issue from the exchange services. We also interviewed officials in the
Office of the Under Secretary of Defense (Personnel and Readiness) and
exchange service representatives to obtain their views on this subject. We
categorized DOD officials? written and oral responses under the general
topics of financial risk, customer service, employment opportunities,
management control, operational risk, and investment opportunities.

We also met with officials of the Marine Corps Community Services office,
which manages all MWR activities for the Marine Corps, to obtain their views
on name- brand, fast- food operations. We also obtained documentation
related to the number of fast- food restaurants located on Marine Corps
installations and their sales and costs for fiscal years 1998 and 1999.
Although we limited our analysis to AAFES and NEXCOM, we did use some of the
Marine Corps data in the background section of this report.

Our methodology has some limitations. First, the financial analysis was
based on historical data that may or may not represent future market
conditions, operating efficiencies, or the way name- brand, fast- food
operations will be carried out in the future. Second, our analysis did not

Appendix I: Scope and Methodology Page 31 GAO- 01- 683 Defense Management

assess the overall tax implications of using the direct and indirect
methods. Presumably, the indirect method would provide tax revenues to the
government because concessionaires? profits are subject to federal taxes and
the direct method would also provide some tax revenues because royalties
paid by an exchange service to the franchiser would also be taxable. Lastly,
our financial analysis considered only one food concept, hamburgers, and may
not be appropriate to other food concepts such as chicken and pizza.

Our work was performed at the Office of Force Management Policy,
Undersecretary of Defense (Personnel and Readiness) in Washington, D. C.;
AAFES headquarters in Dallas, Texas; NEXCOM headquarters in Virginia Beach,
Virginia; the Food and Hospitality Branch, Marine Corps Community Services,
United States Marine Corps at Quantico, Virginia; the Army Community and
Family Support Center in Alexandria, Virginia; and the Air Force Combat
Support and Community Services Office, in Washington, D. C. We also met with
representatives of the Burger King Corporation located in Miami, Florida,
and McDonald?s Corporation located in Oak Brook, Illinois. We performed our
work from September 2000 through May 2001 in accordance with generally
accepted government auditing standards.

Appendix II: Fiscal Year 1999 Inventory of AAFES and NEXCOM Fast- Food
Restaurants

Page 32 GAO- 01- 683 Defense Management

AAFES NEXCOM Direct Facilities Sales Facilities Sales

Name- brand, fast- food 324 $249,064,463 27 $3,689,329 Other food 993
$214,515,148 161 $35,654,669 Deactivated food facilities a 92 $5,700,379 b

Total direct 1,409 $469,279,989 188 $39,343,998 Indirect

Name- brand, fast- food 29 $19,016,589 193 $92,257,892 Other food 284
$24,134,321 53 $22,007,643

Total indirect 313 $43,150,910 246 $114,265,534 Total food 1,722
$512,430,899 434 $153,609,532

a During fiscal year 1999, AAFES closed or deactivated 92 restaurants. The
sales for these restaurants are shown as a separate total. b Data was not
available from NEXCOM. NEXCOM officials told us that this number is likely
insignificant. Source: AAFES and NEXCOM fast- food financial and inventory
data.

Appendix II: Fiscal Year 1999 Inventory of AAFES and NEXCOM Fast- Food
Restaurants

Appendix III: Comments From the Department of Defense Page 33 GAO- 01- 683
Defense Management

Appendix III: Comments From the Department of Defense

Appendix III: Comments From the Department of Defense Page 34 GAO- 01- 683
Defense Management

Appendix III: Comments From the Department of Defense Page 35 GAO- 01- 683
Defense Management

Appendix IV: Staff Acknowledgments Page 36 GAO- 01- 683 Defense Management

Cherry Clipper, Eric Essig, Cleggett Funkhouser, James Fuquay, James
Hatcher, Charles Perdue, Bob Preston, Jerry Thompson, and John Van Schaik
made key contributions to this report. Appendix IV: Staff Acknowledgments

Acknowledgments

Glossary Page 37 GAO- 01- 683 Defense Management

This glossary is provided for reader convenience in understanding terms as
they are used and applied in this report, not as authoritative or complete
definitions.

A percentage paid on gross sales either as a flat percentage rate or a
graduated rate based on sales brackets identified in the contract between
the exchange and the franchise.

A food service provided under contract to provide any segment of food
service, either branded or non- branded, at a given installation in a
permanent structure or temporary unit (i. e., mobile unit or kiosk).

The opportunity cost (or economic cost) associated with alternative uses for
invested capital of comparable risk. Includes funds invested in buildings,
equipment (including periodic renovations and upgrades) and inventory.

The operation of either non- branded or branded food service staffed by an
exchange service?s direct hire associates. The exchange is responsible for
providing/ building and maintaining its own facilities, inventory,
equipment, utilities, financial records, and personnel.

Method of measuring the cash inflows and outflows of a capital investment or
project as if the flows occurred at a single point in time so that they can
be appropriately compared. Because the method considers the time value of
money, it is usually the best method to use for evaluating long- term
investment decisions.

Net profit less the opportunity cost, also referred to as the cost of
capital, associated with invested capital.

A restaurant chain, either nationally or regionally recognized, providing a
standardized system of policies, procedures, marketing/ advertising schemes,
logos, trademark, source of supply, source of equipment, and access to the
franchise contracts.

The operation of either non- branded or branded food service by a
concessionaire or third- party contractor via a contract with an exchange
service.

A term for the legally binding agreement between a franchisee and a
franchiser. Glossary

Commissions Concession Cost of capital Directly operated Discounted cash
flow Economic earnings Franchise

Indirectly operated License agreement

Glossary Page 38 GAO- 01- 683 Defense Management

An amount, usually paid on a per site basis, for the right to operate a
concession at awarded site( s). The fee is remitted to the exchange service
prior to the sites? or facilities? availability/ operational date.

Refers to a food service concept that is national (more than 10 states),
regional (less than 10 states), or in- house (operated only with a given
company?s units).

A nationally recognized fast- food restaurant chain that operates in more
than 10 states.

The dollars that are left after sales or revenues have offset expenses. The
dollars can be expressed at current value or at a discounted value, if the
time value of money is considered.

A discounted cash flow technique that calculates the expected net monetary
gain or loss from a project by discounting all expected future cash inflows
and outflows to the present point in time, using a specified rate of return.

Total sales/ revenues less operating costs and overhead costs. The cost of
goods sold and operating expenses, including depreciation. Refers to
economic earnings for the direct method of operation or net profit for the
indirect method of operation and is expressed as a percentage of restaurant
sales. Under the direct method, profitability represents a restaurant?s
total revenues less its operating costs, overhead costs, and the opportunity
costs associated with invested capital (the cost of capital). Under the
indirect method, profitability represents the revenues (sales commissions,
signing bonuses, and licensing fees) received from the name- brand company
less the exchange service?s overhead costs.

An agreement between a DOD nonappropriated fund activity, such as an
exchange service, and a non- federal entity under which the non- federal
entity provides goods, services, or facilities to authorized MWR activities
and exchange patrons. The non- federal entity may provide a portion or all
of the financing, design, construction, equipment, and staffing associated
with the activity. Licensing fee

Name- brand Name- brand, fast- food Net cash flow

Net present value Net profit Operating costs Profitability

Public- private venture

Glossary Page 39 GAO- 01- 683 Defense Management

Under the direct method, revenue includes restaurant sales plus other
income. Other income is primarily the proceeds from selling surplus
equipment and additional revenue realized in overseas locations from foreign
currency conversions at the point of sale. Revenues under the indirect
method are sales commissions based on restaurant sales plus licensing fees
and signing bonuses.

Gross restaurant or food sales less all applicable taxes and coupon
redemptions recorded at the point of sale.

A lump sum payment made to an exchange service by a concessionaire or a
third- party contractor at the time a contract is signed. Revenues

Sales Signing bonus

(709550)

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