    Defense Acquisitions: Termination Costs Are Generally Not a
    Compelling Reason to Continue Programs or Contracts That
    Otherwise Warrant Ending (14-MAR-08, GAO-08-379).

    The nation's long-term fiscal imbalances will likely make DOD's
    $1.6 trillion planned investment in new weapon systems
    unsustainable. Thus, it is critical that DOD retains the
    flexibility to end programs and contracts when necessary and
    appropriate. Although the federal government generally has the
    legal right to terminate contracts for convenience, defense
    stakeholders have sometimes expressed concerns that it will cost
    more to terminate a contract than to complete it. To address this
    perception, GAO examined (1) how expected contract termination
    costs and other factors affect DOD decisions on whether to end
    programs and contracts; (2) the circumstances under which it
    would cost more to terminate a contract for convenience than to
    complete it; and (3) the options DOD has for retaining value or
    reducing costs, when DOD ends programs or contracts. To do this,
    GAO examined DOD data on terminated contracts over $100 million;
    reviewed laws, regulations, and guidance; and met with key DOD
    officials.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-08-379
        ACCNO:   A81327
      TITLE:     Defense Acquisitions: Termination Costs Are Generally Not
    a Compelling Reason to Continue Programs or Contracts That
    Otherwise Warrant Ending
         DATE:   03/14/2008
      SUBJECT:   Contract administration
    	     Contract costs
    	     Contract modifications
    	     Contract oversight
    	     Contract termination
    	     Contract termination costs
    	     Cost analysis
    	     Cost reimbursement contracts
    	     Defense cost control
    	     Department of Defense contractors
    	     Fiscal policies
    	     Fixed price contracts
    	     Internal controls
    	     Military technology
    	     Program evaluation
    	     Weapons systems
    	     Cost awareness
    	     Fiscal imbalance

    ******************************************************************
    ** This file contains an ASCII representation of the text of a  **
    ** GAO Product.                                                 **
    **                                                              **
    ** 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-08-379

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed
    in its entirety without further permission from GAO. Because this work
    may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this
    material separately.

    Report to Congressional Committees:

    United States Government Accountability Office:

    GAO:

    March 2008:

    Defense Acquisitions:

    Termination Costs Are Generally Not a Compelling Reason to Continue
    Programs or Contracts That Otherwise Warrant Ending:

    Contract Terminations for Convenience:

    GAO-08-379:

    GAO Highlights:

    Highlights of GAO-08-379, a report to congressional committees.

    Why GAO Did This Study:

    The nation�s long-term fiscal imbalances will likely make DOD�s $1.6
    trillion planned investment in new weapon systems unsustainable. Thus,
    it is critical that DOD retains the flexibility to end programs and
    contracts when necessary and appropriate.

    Although the federal government generally has the legal right to
    terminate contracts for convenience, defense stakeholders have
    sometimes expressed concerns that it will cost more to terminate a
    contract than to complete it. To address this perception, GAO examined
    (1) how expected contract termination costs and other factors affect
    DOD decisions on whether to end programs and contracts; (2) the
    circumstances under which it would cost more to terminate a contract
    for convenience than to complete it; and (3) the options DOD has for
    retaining value or reducing costs, when DOD ends programs or contracts.
    To do this, GAO examined DOD data on terminated contracts over $100
    million; reviewed laws, regulations, and guidance; and met with key DOD
    officials.

    What GAO Found:

    Contract termination costs were generally not a major factor in
    Department of Defense (DOD) decisions to end programs or contracts for
    the weapon systems GAO reviewed. GAO found that these program
    cancellations were driven by factors such as changes in warfighter need
    and budgetary constraints. In the contract termination decisions GAO
    reviewed, DOD considered termination costs, but they were generally not
    as significant as other factors, such as contract cost growth.

    For the contracts reviewed, GAO found that it did not cost more to
    terminate than to complete them. When the government terminates a
    contract for convenience, it must compensate the contractor for the
    incurred costs on the completed work, a fee or profit on that work, and
    the termination costs. Federal regulations place various limits on this
    compensation for both cost-reimbursement and fixed-price contracts. GAO
    found eight fully terminated contracts of weapon systems that were over
    $100 million in value, terminated after 1995, and for which data were
    available. Of these, none cost more to terminate than to complete.

    When a program or contract ends, DOD can retain some value from the
    work completed. For example, DOD can end the work immediately and
    transfer materials or technology to other efforts. Alternatively, DOD
    can modify the scope of a contract and complete a limited portion of
    the original work.

    GAO's review of DOD�s past experience with terminations highlights
    important lessons for DOD in making decisions to cancel individual
    programs as well as in managing its broader investment portfolio. For
    example, when considering cancellation of individual programs, contract
    termination costs are generally not a compelling reason to continue
    programs or contracts that otherwise warrant ending. Moreover, while
    incurred or "sunk" costs in programs being considered for termination
    may be substantial, they must be paid regardless of whether or not a
    contract is terminated. Therefore, the decision to terminate a contract
    or cancel a program should not be driven by sunk costs.

    From an investment portfolio perspective, terminations can be a
    valuable tool in responding to long-term fiscal imbalances as well as
    unexpected events that could constrain spending. More specifically,
    they can be used to create more trade space in the over $850 billion
    that still remains in outstanding commitments in DOD's planned $1.6
    trillion investment in weapons programs. However, to make the most
    effective use of this tool, decision-makers need to be able to
    anticipate and plan for possible terminations and have a sound
    understanding of costs, benefits, and legal requirements. As a result,
    guidance on terminations developed by the military services and other
    DOD entities should be clear, consistent, proactive, and detailed
    enough to provide the knowledge needed to use terminations as an
    investment portfolio tool.

    What GAO Recommends:

    GAO recommends that DOD review, and as needed amend, guidance on
    terminations across the military services and DOD agencies to ensure
    that termination guidance identifies the conditions under which it is
    appropriate to end programs or contracts, and provides knowledge needed
    to use terminations as an investment portfolio tool. DOD agreed.

    To view the full product, including the scope and methodology, click on
    [hyperlink, http://www.GAO-08-379]. For more information, contact
    Cristina Chaplain at (202) 512-4841 or ChaplainC@gao.gov.

    [End of section]

    Contents:

    Letter:

    Results in Brief:

    Background:

    Contract Termination Costs Generally Do Not Drive Program Cancellation
    or Contract Termination Decisions:

    Terminating a Contract Generally Costs Less than Completing It:

    DOD Has Options for Retaining Value or Reducing Costs when Programs Are
    Canceled or Contracts Are Terminated:

    Conclusions:

    Recommendation:

    Agency Comments and Our Evaluation:

    Appendix I: Termination Costs and Settlement Amounts:

    Appendix II: Comments from the Department of Defense:

    Appendix III: GAO Contact and Staff Acknowledgments:

    Table:

    Table 1: Contracts Over $100 Million Terminated Since 1995:

    Figures:

    Figure 1: Contracts Terminated for Convenience Processed by DCMA in FY
    2006 by Contract Price of Items Terminated:

    Figure 2: Costs Included in the Total Settlement:

    Figure 3: Termination Costs versus the Value of the Remaining Work:

    Figure 4: Termination Costs versus the Value of Remaining Work for
    Fixed-Price Contracts:

    Figure 5: Components of a Settlement:

    Figure 6: Two Possible Contract Cost Curves:

    Figure 7: Cost Implications of Delaying a Termination Decision:

    Figure 8: The Break-Even Point:

    Abbreviations:

    CPIT: Contract Price of Items Terminated:

    DCMA: Defense Contract Management Agency:

    DOD: Department of Defense:

    FAR: Federal Acquisition Regulation:

    LCS: Littoral Combat Ship:

    NLOS-C: Non-Line-of-Sight Cannon:

    OSD: Office of the Secretary of Defense:

    TSSAM: Tri-Service Standoff Attack Missile:

    United States Government Accountability Office:

    Washington, DC 20548:

    March 14, 2008:

    Congressional Committees:

    In 2007, Department of Defense (DOD) planned investment in new weapon
    systems totaled $1.6 trillion. Of this, over $850 billion remains in
    outstanding commitments. Prior GAO work has shown that the nation's
    long term fiscal imbalances, as well as DOD's tendency to start more
    programs than current and likely future resources can support, will
    place pressure on the agency's ability to carry out planned
    investments. Given this, as well as continual cost overruns and
    performance problems among some weapon programs, it is critical that
    DOD retains the flexibility to cancel programs and terminate contracts
    when necessary. Program cancellation decisions are related to but
    separate from contract termination decisions. When canceling a program,
    DOD may complete a contract, or it may terminate a contract if it is in
    the interests of the government. While DOD terminates hundreds of
    contracts for convenience in part or in whole each year, fewer than a
    dozen contracts terminated since 1995 were worth more than $100
    million. Although the government generally has the legal right to
    terminate contracts for its convenience, there are costs associated
    with doing so. In recent years, defense stakeholders have sometimes
    expressed concerns that it will cost more to terminate a contract than
    to complete it. In order to address this perception and better
    understand the relationship between DOD's decision making and contract
    termination costs, this report will examine (1) how expected contract
    termination costs and other factors affect DOD decisions on whether to
    cancel programs and terminate contracts, (2) the circumstances under
    which it would cost more to terminate a contract for convenience than
    to complete it, and (3) the options DOD has for retaining value or
    reducing costs when programs are canceled or contracts are terminated.

    We prepared this report under the authority of the Comptroller General
    of the United States to conduct evaluations on his own initiative. We
    conducted our work at the Department of Defense, including the Office
    of the Secretary of Defense (OSD), Army, Air Force, Department of the
    Navy, and Defense Contract Management Agency (DCMA). To understand
    program acquisitions, related contracting practices, and the
    cancellation of programs and termination of contracts, we reviewed
    relevant laws, regulations, and guidance related to program management
    and contract terminations for convenience. We reviewed data on
    terminated contracts from the DCMA Terminations Center database, which
    has data on programs for which DCMA has handled the termination. For
    the purposes of this review, we reviewed all fully terminated contracts
    in the DCMA database--both fixed-price and cost-reimbursement--of
    weapons systems that were over $100 million in value and were
    terminated after 1995. In addition, we examined a termination of a
    weapon system contract that had been handled by its program office and
    was not in the DCMA database--the Comanche helicopter. This was the
    only weapon system contract terminated after 1995 for over $100 million
    that DOD officials were able to identify that was not terminated by
    DCMA.[Footnote 1] We met with officials at DOD and at the Army, Air
    Force, and the Department of the Navy to discuss programs that had been
    canceled and contracts that had been terminated. In addition, we
    reviewed programs and/or contracts that had been publicly discussed for
    cancellation and/or termination, for which data were readily available,
    but were not canceled or terminated, such as the C-130J Air Force cargo
    airplane program.

    We conducted our review from October 2006 to March 2008 in accordance
    with generally accepted government auditing standards. Those standards
    require that we plan and perform the audit to obtain sufficient,
    appropriate evidence to provide a reasonable basis for our findings and
    conclusions based on our audit objectives. We believe that the evidence
    obtained provides a reasonable basis for our findings and conclusions
    based on our audit objectives.

    Results in Brief:

    Termination costs for the contracts we reviewed were generally not as
    significant as other factors in making program cancellation and
    contract termination decisions. Rather, the weapon systems we reviewed
    tended to be canceled when they no longer met warfighter need or when
    they did not fit within budget constraints. For example, the Crusader
    howitzer was canceled because the warfighter no longer needed a 60-ton
    armored cannon to combat Soviet forces on the battlefields of Europe.
    Termination costs were also not cited by DOD officials as a major
    factor in contract termination decisions. Instead, contracts were
    terminated because the program was canceled or because the contractor
    experienced cost growth. Of the programs and contracts that we
    reviewed, anticipated termination costs were only significant in
    reversing the decision to terminate the C-130J cargo plane contract.
    The decision to terminate this contract was made for budgetary reasons;
    however, higher than anticipated termination cost estimates were a key
    factor in reversing the decision.

    There are limited circumstances in which it could cost the government
    more to terminate a contract than to complete it. The Federal
    Acquisition Regulation (FAR) specifies the categories of costs a
    contractor may be entitled to when the government terminates a contract
    for convenience. These costs include incurred costs, a reasonable fee/
    profit, and termination costs such as disposing of inventories and
    negotiating with subcontractors. Provisions in the FAR limit the total
    settlement amount (the total amount paid on the terminated contract)
    paid to the contractor. For example, the FAR generally limits the
    government's liability under a fixed-price contract to the contract
    price plus termination costs.[Footnote 2] Therefore, it would only cost
    more to terminate a fixed-price contract than to complete it if the
    termination costs were greater than the cost of the remaining work
    under the contract. The government's liability in the event of a
    contract termination is also limited under cost-reimbursable contracts.
    Of the eight contracts we reviewed, we did not find any cases in which
    the termination settlement exceeded the estimated contract price.

    When a line of work ends by either a program cancellation or a contract
    termination, DOD may be able to recover useful items, information, or
    technology that can reduce costs on other DOD programs. More
    specifically, when a contract is nearly complete, it may be in the
    government's best interest to complete the contract, rather than
    terminate it. For example, on the canceled E-10A program, Air Force
    officials decided to complete the contract for the aircraft, because
    the program only had to make one additional payment to take delivery of
    the plane. When a contract is terminated, DOD can take steps to retain
    value by transferring technology, information, and property to other
    efforts. For example, when the Army's Comanche helicopter program was
    canceled, the Army transferred flight control system technology and
    70,000 line items of property to other DOD programs. Finally, DOD can
    also continue a limited amount of work on a line item of a terminated
    contract if this will result in technology or items in production that
    could be used in the future. When the Littoral Combat Ship 3 (LCS-3)
    was terminated, for example, the Navy decided to continue work on the
    gears and gas turbines for use on other ships.

    We are recommending that DOD review, and as needed amend, guidance on
    terminations across the military services and DOD entities to ensure
    that termination guidance consistently identifies the conditions under
    which it is appropriate to end programs or contracts, and provides
    knowledge needed to use terminations as an investment portfolio tool.

    DOD concurred with our recommendation to review, and amend as needed,
    guidance on contract terminations for convenience across the military
    services and DOD. This is a positive step toward using terminations as
    an investment portfolio tool.

    Background:

    Over the life cycle of a weapon system, DOD typically executes several
    contracts with a prime contractor for the program. These contracts
    cover development, production, or maintenance efforts. Although a
    program and its contracts are related, they are separate, distinct
    efforts that can end separately. For the purposes of this review, we
    refer to the end of a program as a cancellation, and the end of a
    contract as a termination. For example, DOD may cancel a program but
    continue a contract related to that program. Alternatively, DOD can
    terminate a contract but continue the program.

    Since most federal contracts are mutually binding legal agreements that
    are governed by the FAR, they must be terminated by proper procedures.
    These procedures include the issuance of a termination notice.
    Programs, in comparison, are institutionally directed and funded
    efforts and not legal agreements.[Footnote 3] Based upon our audit
    work, program cancellations may be done through an official program
    document such as an acquisition decision memorandum. However,
    documenting cancellations with a memorandum is not a DOD requirement
    and DOD does not have specific guidance on how a program is to be
    officially ended.

    The programs we reviewed used two broad categories of contracts: cost-
    reimbursement and fixed-price. In cost-reimbursement contracts, the
    contractor is reimbursed for allowable[Footnote 4] costs incurred,
    regardless of whether the anticipated work is completed. As a result,
    the exact final cost of a cost-reimbursement contract may often not be
    known at the start of a contract. In such cases, cost-reimbursement
    contracts will have an estimated total cost for purposes of
    establishing a not-to-exceed dollar value, which may be exceeded only
    with the approval of the contracting officer. Contractors with cost-
    reimbursement contracts may also be provided incentives, generally
    referred to as fees, through various metrics that assess the
    contractor's performance and reward that performance
    accordingly.[Footnote 5] For fixed-price contracts, the government
    agrees to pay the contractor a prenegotiated price for a product or
    service and, therefore, the price is typically known at award.
    Contractors with fixed-price contracts can also be provided additional
    incentives based upon performance metrics. For DOD weapon systems, most
    development is typically done with cost-reimbursement contracts, and
    production can be done with fixed-price contracts.

    Generally, parties' obligations under contracts end when the required
    performance is completed, that is, when the government has accepted the
    supplies or services and paid the contractor in full. However, if a
    contractor has not performed as agreed, the government may choose to
    end its obligations by terminating the contract for default. In other
    cases, however, even when the contractor is performing acceptably, it
    may be in the interest of the government to end its contractual
    obligations before the contract is completed. To acknowledge the unique
    position of the federal government in such circumstances, a legal right
    to terminate procurement contracts for the government's convenience has
    developed. This right gives the government--e.g., DOD and other federal
    agencies--the option to terminate a contract for convenience when
    changed circumstances, such as the end of a war, mean termination is in
    the government's interests.[Footnote 6] If the government did not have
    this right, in order to prematurely end a contract, the government
    might breach its contract and potentially pay damages to the
    contractor, which would result in unnecessary expenditure of government
    funds and expenses for the taxpayer. For example, DOD officials told us
    that when the Gulf War ended, DOD no longer needed large quantities of
    prepackaged, shelf-stable meals and thus terminated those contracts for
    convenience.

    As mentioned earlier, when a contractor is unable to meet the terms and
    conditions of the contract, the government may terminate the contract
    for default. DOD officials, in reference to contracts for weapon
    systems, told us that while a termination for default might be
    considered, the standard for proving default is so high that instead,
    terminations for convenience are often done.[Footnote 7] The Navy's A-
    12 stealth attack aircraft program illustrates the difficulty of
    pursuing a termination for default. In 1991, the Navy terminated the A-
    12 contract for default. In doing so, the Navy contended that the
    contractors were behind schedule and unable to deliver an aircraft that
    met the contract requirements. The contractors challenged the
    termination, resulting in 16 years of litigation, which was still
    ongoing at the time we did our work. The contractor contended that a
    termination for default is only permitted when it is absolutely
    impossible for the contractor to complete the work or when the
    contractor completely abandons the work. In this case, a termination
    for default would require the contractors to repay over a billion
    dollars in progress payments, as opposed to a termination for
    convenience in which the contractor would be eligible to recover its
    incurred costs.

    The FAR requires that a termination for convenience clause be included
    in most federal procurement contracts[Footnote 8], granting the
    government the right to terminate the contract prior to
    completion.[Footnote 9] In a complete termination for convenience, the
    contract ends on the date specified in the government's notice of
    termination. The FAR also gives the government the right to partially
    terminate a contract for convenience, meaning the government can choose
    to terminate only a portion of the contract. In contrast, the
    contractor is not given a right to terminate for convenience, and this
    type of contractual right is rare outside the world of federal
    government contracting.

    The process for terminating a contract for convenience is specified in
    the FAR.[Footnote 10] When the government terminates a contract for
    convenience, the contracting officer must send a written termination
    notice to the contractor indicating whether the termination is for
    convenience or default. The written notice may also contain, special
    instructions, and in some cases personnel mitigation efforts.[Footnote
    11] Upon receiving the notice of termination, the contractor is
    required to stop all work immediately under the terminated portion of
    the contract and terminate all related subcontracts. When inventories
    exist, the contractor must, as directed by the contracting officer,
    deliver to the government a "termination inventory" that lists
    materials produced or acquired under the contract and government-
    furnished property[Footnote 12] and account for all inventory related
    to the terminated portion of the contract by completing termination
    inventory schedules, generally within 120 days of the effective date of
    the termination.[Footnote 13] The contractor must dispose of all
    remaining property, as agreed with the government.[Footnote 14] The
    contractor also begins the process of settling with its
    subcontractors.[Footnote 15]

    The contractor has 1 year from the effective date of the termination to
    submit a settlement proposal to the contracting officer, unless the
    period is extended by the contracting officer handling the
    termination.[Footnote 16] The amount of the settlement proposal
    reflects all of the costs for which the contractor believes it is
    entitled to be reimbursed, including incurred costs for work performed,
    termination costs, plus in some cases, a reasonable profit or fee on
    its completed work, minus all payments made to date and the value of
    the property the contractor retained upon termination.[Footnote 17]
    When the contracting officer receives the contractor's settlement
    proposal, he or she can choose to pay the proposed amount or negotiate
    with the contractor.[Footnote 18] If the contractor does not submit a
    settlement proposal within 1 year from the effective termination date,
    or if the contracting officer cannot reach agreement with the
    contractor, the contracting officer may unilaterally decide on the
    amount to which the contractor is entitled, applying the standards that
    are set forth in the FAR. The FAR also provides the contractor the
    right to appeal[Footnote 19] the termination settlement to the
    applicable Board of Contract Appeals[Footnote 20] or to the United
    States Court of Federal Claims, if the contractor has met its deadline
    for submission of the settlement proposal.[Footnote 21]

    At DOD, when a procuring activity decides to terminate a contract for
    convenience, although it is not required to do so, it may employ the
    assistance of the termination contracting officers at the DCMA
    Terminations Center. The Terminations Center employs contracting
    officers who specialize in terminations for convenience and whose only
    mission is to settle contracts terminated for the convenience of the
    government. In fiscal year 2006, the Terminations Center data show that
    DCMA processed about 600 terminations.[Footnote 22] Figure 1 shows that
    only 10 percent of these terminated contracts involved terminated items
    valued at more than $1 million.

    Figure 1: Contracts Terminated for Convenience Processed by DCMA in FY
    2006 by Contract Price of Items Terminated:

    This figure is a pie chart showing contracts terminated for convenience
    processed by DCMA in FY 2006 by contract price of items terminated.

    36%: $5,001-$50,000;
    17%: $50,001-$100,000;
    22%: $100,001-$500,000;
    6%: $500,001-$1,000,000;
    10%: Greater than $1,000,000;
    9%: $1-$5,000.

    [See PDF for image]

    Source: Data from the DCMA Terminations Center.

    Note: DCMA's Contract Price of Items Terminated (CPIT) is the value of
    the terminated portions of the contract. Under a complete termination,
    CPIT would equal the contract price. Under a partial termination, CPIT
    would equal only the value of the portion of the contract that was
    terminated.

    [End of figure]

    Contract Termination Costs Generally Do Not Drive Program Cancellation
    or Contract Termination Decisions:

    When DOD decides to cancel a program or terminate a contract,
    termination costs are generally not a major factor in these decisions.
    DOD officials told us that the weapon systems we reviewed were canceled
    for two primary reasons: when they no longer met warfighter need or
    when they did not fit within budget constraints. While programs may
    have experienced cost growth, schedule slippages, poor performance, and
    changing requirements, cancellations were generally driven by
    warfighter need and budgetary constraints. In contrast, DOD officials
    did not cite contract termination costs as a major factor in program
    cancellation decisions. In addition, while termination costs were
    considered, DOD officials did not mention them as a major factor in
    contract termination decisions. The one exception that we found was the
    C-130J cargo plane in which higher than anticipated termination costs
    were a key factor in reversing the decision.

    Factors That Influence Program Cancellation Decisions:

    Figure:

    Crusader (Army);

    Prime contractor: United Defense Limited Partnership;
    Program started: 1987;
    Last contract awarded: 1995;
    Contract price: $1.87 billion;
    Contract terminated: 2002;
    Total settlement: $1.66 billion;

    [See PDF for image]

    Source: United Defense Limited Partnership.

    The Crusader�an automated, next- generation field artillery system�was
    designed to have greater firepower, range, and mobility than the
    existing self-propelled howitzer. In 2000, the Army changed its
    requirements to make the Crusader lighter and more deployable by air.
    However, the program was unable to achieve lower weight requirements
    within cost and schedule limitations. Ultimately, the Crusader was
    canceled because the Army needed a more mobile and deployable force as
    opposed to a 60-ton armored cannon designed to combat Soviet forces on
    the battlefields of Europe. The Army was able to transition nearly
    26,000 inventory line items�valued at more than $150 million�from the
    Crusader to create the Non-Line-of-Sight Cannon program as well as an
    additional 9,800 inventory line items�valued at $25.8 million�to other
    DOD programs.

    [End of figure]

    Among the programs that we reviewed, contract termination costs did not
    drive program cancellation decisions; rather, DOD canceled programs
    when they no longer met warfighter need or when they did not fit within
    budgetary constraints. For example, according to a program official,
    the Crusader--an automated, self-propelled howitzer--was canceled
    because the warfighter no longer needed a 60-ton armored cannon to
    combat Soviet forces on the battlefields of Europe. Similarly, Army
    officials determined that the operating environment faced by the
    warfighter had changed and funds for the Comanche helicopter would be
    better spent on other aviation priorities. Furthermore, the Comanche
    program had experienced schedule slips and cost overruns. When
    interviewed about the Comanche cancellation, an Army official told us
    that the program's costs could no longer be justified.

    Even if a program can deliver a useful capability, officials told us
    that DOD may still decide to cancel the program to meet projected
    budgetary constraints. For example, although Air Force officials stated
    that there is still a need for the E-10A, an air-to-air and air-to-
    ground radar platform, DOD canceled the program to match expenditures
    against future budgets. Army officials stated that in recent years the
    Army has also canceled programs for budgetary reasons. Army officials
    told us that in the fiscal year 2008 budget request, the Army is
    proposing to cancel 10 programs in order to meet the budget shortfall.
    DOD officials confirmed that each service has a process to assess its
    needs and resources over a 6-year time frame, but only the Army has a
    formal process as part of its annual budget cycle to cancel the least
    needed programs to cover a budget shortfall.

    Factors That Influence Contract Termination Decisions:

    Figure:

    C-130J (Air Force);

    Prime contractor: Lockheed Martin;
    Aeronautics Company�Marietta;
    Program started: 1996;
    Contract began: 1996;
    Total program costs: $8.07 billion (as of December 2006).

    [See PDF for image]

    Source: C-130J Program Office.

    The C-130J is the latest addition to DOD�s fleet of C-130 aircraft. The
    C-130J climbs faster and higher, flies farther at a higher cruise
    speed, and takes off and lands in a shorter distance than older models
    and is designed primarily for the transport of cargo and personnel
    within an area of armed conflict. The contract was considered for
    termination due to budgetary reasons, but ultimately the Air Force
    decided not to terminate the contract because estimated termination
    costs were higher than expected.

    [End of figure]

    Contract termination costs generally did not drive contract termination
    decisions; rather, officials told us that the contracts were terminated
    because of cost growth or because the program that the contract
    supported was canceled. For example, the Navy canceled the third and
    fourth Littoral Combat Ships (LCS-3 and LCS-4) following a series of
    cost overruns and schedule delays on LCS-1 and LCS-2 as well as an
    inability to reach an agreement with the prime contractors to modify
    their existing cost-reimbursement contracts to fixed-price
    contracts.[Footnote 23] Navy officials stated that termination costs
    were considered before the termination decision was made, but the
    estimates of these costs were not significant enough to affect the
    decision. Both the Crusader and the Comanche contracts were terminated
    because their respective programs were canceled. In contrast,
    termination costs did play a role in the reversal of the decision to
    terminate the C-130J cargo plane. Estimated termination costs for the C-
    130J were high enough to reverse the initial decision, though these
    estimates were still less than the contract price. Air Force officials
    estimated that termination costs ranged from $450 million to $1.7
    billion. The Department of Defense Inspector General reported that this
    estimate may have been overstated. Nevertheless, the termination cost
    estimate that the officials had at the time of their decision played a
    key role in continuing the C-130J contract.

    Terminating a Contract Generally Costs Less than Completing It:

    It generally costs less to terminate a contract than to complete it.
    When the government terminates a contract for convenience, it must
    compensate the contractor in the form of a termination settlement,
    which includes the costs of work performed and termination costs.
    Settlements are typically less than the cost of completing a contract,
    although in limited circumstances it could cost more to terminate than
    to complete a contract. And while we found no examples in which it cost
    more to terminate than to complete a contract, the timing of a
    termination as well as contract specific factors may increase the
    settlement amount.

    A Termination Settlement Compensates the Contractor for Work Performed
    and Termination Costs:

    When the government decides to terminate a contract for convenience, it
    must compensate the contractor fairly--in the form of a termination
    settlement (hereafter referred to as a settlement)--for the work it has
    performed.[Footnote 24] Settlements generally include three components:
    incurred costs for the work performed, fee or profit on that work, and
    termination costs.[Footnote 25] (See fig. 2.) Settlements only include
    costs related to a terminated contract and therefore will not reflect
    additional costs that may be a result of a termination, but outside the
    scope of the contract, such as a larger community effect--for example,
    a contractor going out of business.

    Figure 2: Costs Included in the Total Settlement:

    This figure is a chart showing costs included in the total settlement.

    Termination costs: Expenses associated with terminating a contract,
    such as preparing a settlement proposal, negotiating with
    subcontractors, and disposing of inventory;

    Fee/profit: Fee (for cost-type contracts) or profit (for fixed-price
    contracts) for the work contractors perform;

    Incurred cost: Cost of contractor work performed.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    The contractor's incurred costs include direct costs such as materials
    and labor, as well as indirect costs such as overhead.[Footnote 26]
    Factors that affect incurred costs include the amount of work performed
    when the contract is terminated and the amount of materials purchased.
    Contractors may choose to retain some of the materials they purchased
    for a terminated contract and would then have to credit the government
    for the value of the materials, thus reducing the total settlement
    amount.

    Figure:

    Tri-Service Standoff Attack Missile (Air Force);

    Prime contractor: Northrop Grumman Corp.;
    Program started: 1986;
    Contract began: 1986;
    Contract price: $2,838,312,523;
    Contract terminated: 1995;
    Total settlement: $2,474,157,972.

    (Photo not available)

    The Tri-Service Standoff Attack Missile (TSSAM) program was an effort
    to develop and acquire a conventional, medium-range cruise missile with
    stealth capability. TSSAM was expected to be a low-cost cruise missile
    able to deliver several different munitions at a standoff range of over
    100 nautical miles. It was a tri-service development program with the
    Air Force as the lead service. The program was marked by significant
    technical problems, cost growth, and schedule delays. In 1994, DOD
    restructured the TSSAM program after a series of flight test failures.
    The Secretary of Defense directed the program�s cancellation because
    these technical problems and escalating costs persisted.

    [End of figure]

    In addition to incurred costs, contractors generally get paid a fee
    (for cost-reimbursement contracts) or profit (for fixed-price
    contracts) for the work they performed.[Footnote 27] Fee/profit under a
    termination only applies to work the contractor performed and not to
    any anticipated fee or profit for the terminated portions of the
    contract. Moreover, for a fixed-price contract, if the contractor
    spends more than the contract price, then the government is generally
    only obligated to pay the contractor the contract price of the work
    completed. For example, when the government terminated a fixed-price
    contract for the Tri-Service Standoff Attack Missile (TSSAM), the
    contractor claimed that it had spent about $3 billion on work that was
    priced at $2.47 billion in the contract. Because the government stated
    that the contractor would have been at a loss due to being over budget,
    the contractor was not entitled to reimbursement for all of its
    expenditures and lost more than $559 million.

    The government also is required to pay contractors for termination
    costs--the expenses associated with terminating a contract, such as
    preparing a settlement proposal, negotiating with subcontractors, and
    disposing of inventory.[Footnote 28] According to a DCMA official,
    termination costs are not associated with performing the work under the
    contract, but rather for ending the contract. Contractors are not
    entitled to reimbursement for legal costs associated with challenging a
    termination for convenience in court, although a contractor may be
    reimbursed for legal costs arising from subcontractor suits.[Footnote
    29]

    A settlement only addresses the government's obligation under a
    terminated contract. According to DOD officials, there may be
    additional costs associated with a termination for convenience.
    However, these costs are not included in the terminated contract's
    settlement. Higher operations and maintenance costs for legacy systems
    that would have been replaced, the costs of awarding a new contract to
    replace a terminated contract, and economic impacts on communities
    where terminated work was to be performed are examples of costs that
    are outside the scope of a settlement, but could potentially result
    from a termination for convenience.

    When a termination is actually settled, the amount paid to the
    contractor may be less than the settlement amount. A settlement is the
    total amount the government must pay under a termination, which may be
    viewed as the gross settlement. However, the government may have paid
    for some of the work prior to termination. In such cases, the
    government would only have to pay the net settlement amount, i.e., the
    gross settlement amount less any payments made to date. For example,
    incurred costs for the terminated Comanche contract were over $2.3
    billion. However, the government had made progress payments over the
    life of the Comanche contract, so the outstanding balance due at the
    time of termination was only a fraction of the incurred costs. To pay
    such outstanding balances, DOD uses the funding already available on
    the contract.

    Comanche (Army);

    Prime contractor: Boeing Sikorsky;
    Program started: 1983;
    Last contract awarded: 2000;
    Contract price: $6.59 billion;
    Contract terminated: 2004;
    Total settlement: $2.74 billion.

    [See PDF for image]

    Source: Boeing Sikorsky.

    The Comanche was the Army's next- generation armed reconnaissance
    helicopter, which would have supplied a system capable of operating in
    adverse weather conditions across a wide spectrum of threat
    environments. It was expected to provide lower operating costs as well
    as improved speed, agility, reliability, and maintainability, and was
    to be harder to detect than existing helicopters. The Comanche program
    experienced substantial cost increases, schedule delays, and
    performance shortfalls. The Army determined that the operating
    environment had changed and that funds would be better spent on other
    aviation priorities. The Comanche was estimated to cost $40 million per
    aircraft whereas both the Kiowa Helicopter and the Armed Reconnaissance
    Helicopter were estimated to cost $10 million each. When the Army
    terminated the program, it transferred the Comanche�s fly-by-wire
    flight control system technology and 70,000 line items of property to
    other Army aviation efforts.

    [End of figure]

    Settlements Are Generally Less than the Cost of Completing the
    Contract:

    In general, it will not cost more to terminate than to complete a
    contract, whether it is a fixed-price contract or a cost-reimbursement
    contract. The FAR places limits on the settlement amount in the event
    of a termination for both types of contracts, although the limits are
    different depending on the contract type.

    Fixed-Price Contracts: It will generally not cost more to terminate
    than to complete a fixed-price contract unless it is terminated late in
    its life. Under the FAR, for fixed-price contracts, incurred costs plus
    profit generally cannot exceed the contract price.[Footnote 30] As long
    as termination costs are allowable, there is no specific dollar limit
    on them. Thus, termination costs, when added to incurred costs and
    profit, could push the settlement amount above the contract price,
    depending on the value of the remaining work. As shown in figure 3
    (case 1), if termination costs are less than the value of the remaining
    work, it would cost less to terminate the contract than to complete it.
    If termination costs are greater than the value of the remaining work,
    then it would cost more to terminate the contract than to complete it,
    as shown in figure 3 (case 2).[Footnote 31]

    Figure 3: Termination Costs versus the Value of the Remaining Work:

    This figure is a flowchart showing termination costs versus the value
    of the remaining work.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    Termination costs are more likely to exceed the value of the remaining
    work late in the life of a fixed-price contract because the
    government's savings as a result of a termination (i.e., the value of
    the remaining work) decrease over the life of a contract. For example,
    if the contract is terminated after 30 percent of the costs under the
    contract have been incurred, the government would save 70 percent of
    the contract price (before accounting for termination costs). It would
    only cost more to terminate the contract than to complete it if
    termination costs were greater than 70 percent of the contract price.
    Figure 4 shows that as the completed work increases, the potential cost
    savings decrease. (Fig. 4 depicts the incurred costs and profit curve
    as linear to illustrate these concepts, but may not reflect actual
    incurred cost and profit curves. See app. I for further discussion of
    how cost and profit curves affect settlements.) Of the contracts we
    reviewed, the TSSAM had the highest termination costs, at $172 million,
    or 6 percent of the contract price. However, the value of the remaining
    work was over 13 percent of the contract price (over $384 million of
    about $2.8 billion), so it cost less to terminate the TSSAM contract
    than to complete it. In determining whether it would cost more to
    terminate a contract than to complete it, we believe the value of the
    termination costs does not matter as much as the ratio of termination
    costs to the value of the remaining work.

    Figure 4: Termination Costs versus the Value of Remaining Work for
    Fixed-Price Contracts:

    This figure is a flowchart showing termination costs versus the value
    of remaining work for fixed-price contracts.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    Cost-reimbursement contracts: Cost-reimbursement contracts generally
    would not cost more to terminate than to complete unless the government
    authorized the contractor to exceed the estimated contract cost. For
    fully funded cost-reimbursement contracts, the FAR's Limitation of Cost
    clause provides that the government is not obligated to reimburse the
    contractor in excess of the estimated cost of the contract.
    Nevertheless, whether the clause's cost limitations act as a total cap
    on the government's liability is sometimes determined on a case-by-case
    basis by courts and agency boards which decide whether it is equitable
    for the agency to provide funding over the estimated cost.[Footnote
    32],[Footnote 33] For all fully funded cost-reimbursement contracts,
    the Limitation of Cost clause requires the contractor to notify the
    government in writing when the total estimated cost of performing the
    contract, exclusive of any fee, will be greater than previously
    estimated.[Footnote 34] The government then has a choice--it must
    notify the contractor in writing that (1) it increased the estimated
    contract cost (and obligated more money to the contract) or (2) the
    contract will be terminated.[Footnote 35] If the contractor's incurred
    costs are equal to the estimated contract cost, the contractor is not
    obligated to perform any work to settle a termination (i.e., dispose of
    inventory or negotiate with sub-contractors). The government would be
    required to add additional funds to pay for termination costs before
    directing the contractor to take actions to settle the
    termination.[Footnote 36] Therefore, while the government is not
    required to pay more under a cost-reimbursement contract than the
    previously estimated contract cost, it may choose to do so when it is
    in its best interest.[Footnote 37]

    For the purposes of this review, we examined eight terminated contracts
    of weapon systems whose contract price or estimated cost exceeded $100
    million. While it is possible that a contract could cost more to
    terminate than to complete, as shown in table 1, we did not find any
    cases in which this occurred.

    Table 1: Contracts Over $100 Million Terminated Since 1995:

    Contract name: Comanche;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $6,586,200,000;
    Total settlement: $2,739,126,125;
    Amount contract price exceeded total settlement: $3,847,073,875.

    Contract name: Tri-Service Standoff Attack Missile;
    Contract type: Fixed-price;
    Contract price at time of termination: $2,838,312,523;
    Total settlement: $2,474,157,972;
    Amount contract price exceeded total settlement: $364,154,551.

    Contract name: Crusader;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $1,873,914,504;
    Total settlement: $1,662,737,672;
    Amount contract price exceeded total settlement: $211,176,832.

    Contract name: B-1 B Defense Systems Upgrade Program;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $282,434,749;
    Total settlement: $257,900,000;
    Amount contract price exceeded total settlement: $24,534,749.

    Contract name: Tomahawk Baseline Improvement Program;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $239,676,147;
    Total settlement: $230,540,804;
    Amount contract price exceeded total settlement: $9,135,343.

    Contract name: Space and Missile Tracking System Low Earth Orbit;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $204,292,000;
    Total settlement: $203,227,527;
    Amount contract price exceeded total settlement: $1,064,473.

    Contract name: Smart Target Activated Fire and Forget;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $162,781,580;
    Total settlement: $156,808,356;
    Amount contract price exceeded total settlement: $5,973,224.

    Contract name: Land Warrior;
    Contract type: Cost-reimbursement;
    Contract price at time of termination: $133,559,667;
    Total settlement: $121,991,538;
    Amount contract price exceeded total settlement: $11,568,129.

    Source: GAO analysis of data from DCMA's Termination Center and the
    Army.

    Note: The contract price for the Space and Missile Tracking System Low
    Earth Orbit at the time of termination was unavailable. This figure
    represents the contract price of items terminated.

    [End of table]

    Some Factors May Increase Settlement Amounts:

    Although we found that it generally does not cost more to terminate a
    contract than to complete it, factors such as the timing of a
    termination, how costs are incurred over the life of a contract, and
    the cost of disposing of inventory and negotiating with subcontractors
    could result in higher settlements. Settlements tend to be lower if a
    contract is terminated sooner rather than later because incurred costs
    increase over time. (See app. I for further discussion of this topic.)
    In addition, any contract in which costs are incurred sooner rather
    than later could potentially increase the settlement amount in the
    event of a termination. Multiyear contracts, for example, allow
    contractors to enter into contracts for a period of up to 5 years so
    that they can purchase more than 1 year's worth of equipment for
    materials from their suppliers. This could result in savings with
    regard to the total estimated cost of carrying out the program if the
    contract is completed, but may also result in higher incurred costs if
    the contract is terminated. For example, if the contractor bought all
    the materials for a 5-year multiyear contract at the beginning of the
    contract and the contract was terminated after the second year, the
    government would have to reimburse the contractor for 3 years' worth of
    materials that it no longer needed. By shifting costs from the fourth
    or fifth year to the first year, a multiyear contract may result in
    higher termination settlements than a series of annual contracts.
    Finally, termination costs are driven in part by the cost of disposing
    of inventory and settlement negotiations, including those between the
    prime contractor and subcontractors. Therefore, a large amount of
    inventory or large number of subcontractors could result in higher
    termination costs, because of the increased time it could take to
    finalize a settlement for each of those situations. In addition, other
    factors such as the complexity of the actual service or product may
    also play a role. For example, as a DOD official stated, disposing of a
    small amount of classified stealth material may cost more because
    classified materials have to be protected and destroyed.

    DOD Has Options for Retaining Value or Reducing Costs when Programs Are
    Canceled or Contracts Are Terminated:

    When a line of work ends by either a program cancellation or a contract
    termination, DOD may be able to recover useful items of value that can
    be used on other DOD efforts. Furthermore, the way in which the work
    ends may affect the value of what DOD is able to recover. The
    government must decide whether it is in its best interest to complete a
    contract, or terminate it and transfer technology, information, and
    property to other DOD programs. For example, both the Comanche and
    Crusader were canceled programs in which DOD had invested billions of
    dollars. Yet following each of those cancellations, the government was
    able to transfer significant amounts of technology and property from
    those programs to other DOD programs.

    Figure:

    E-10A (Air Force);

    Prime contractor: Northrup Grumman Corp.;
    Program started: 2003;
    Program canceled: 2007;
    Estimated program cost: $1.61 to $1.74 billion[A];

    [See PDF for image]

    Source: Northrup Grumman Corp.

    [End of table]

    The E-10A was a plane equipped with radar that was intended to provide
    next-generation air and ground moving target detection capabilities and
    an imaging capability for surface surveillance. Through a DOD program
    budget decision, the budget was restructured and the program was
    canceled. However, none of the contracts associated with the program
    were terminated. The Air Force plans to complete the commercial-item,
    fixed-price contract to obtain the plane. The Air Force also descoped
    and continued acquisition of the radar under a modified contract for
    use on the Global Hawk. The contract to integrate the radar and the
    plane was discontinued at the end of the period of performance.

    [A] Program officials were unable to give an exact value because the
    radar contract included funding for a variant to be used on another
    system, the Global Hawk.

    [End of figure]

    DOD Can Complete the Original Contract or Modify It: When a contract is
    nearly complete, it may be in the government's best interest to
    complete it rather than terminate it, even when the associated program
    has been canceled. For example, when DOD canceled the E-10A program,
    Air Force officials examined the program in order to determine how to
    most effectively end work on the program's various contracts. Under the
    E-10A program, the Air Force had entered into a commercial-item, fixed-
    price contract to purchase a plane and a separate cost-reimbursement

    contract for the radar. Air Force officials decided to complete the
    contract for the plane by making one final payment to take delivery of
    it. Had the Air Force terminated this commercial contract, it would
    have received nothing of value in return.[Footnote 38] In addition, the
    Air Force decided not to terminate the radar contract, but to descope
    it and continue it under a modified contract.

    Figure:

    Littoral Combat Ship (Navy);

    The Littoral Combat Ship (LCS) is designed to counter threats from
    mines, submarines, and surface craft in shallow water, where there is
    currently a capability gap. The LCS program has experienced substantial
    design changes, schedule delays, and cost growth. The Navy anticipates
    LCS-1 and LCS-2 to exceed their combined budget of $472 million by more
    than 100 percent and anticipates lead ship delivery to occur
    approximately 18 months later than initially planned. Due to these
    challenges, the Navy stopped construction of the LCS-3 and LCS-4 after
    failing to reach agreement with the prime contractors to modify the
    existing cost-reimbursement contracts to fixed-price contracts. Because
    a significant amount of work on the gears and gas turbines on LCS-3 had
    been completed, the Navy completed work on these items for use on other
    ships.

    [See PDF for image]

    Source: U.S. Government.

    [End of table]

    DOD Can Terminate a Contract and Transfer Technology or Property: When
    a contract is terminated, DOD can take steps to retain value by
    transferring technology, information, and property to a new or ongoing
    program. For example, in the wake of the Crusader termination, the Army
    transferred almost 26,000 inventory line items (valued at more than
    $150 million) from the Crusader to create the Non-Line-of-Sight-Cannon
    (NLOS-C) program. According to one Army official, the technology
    transfer also preserved DOD's technical and scientific expertise in its
    armored community. Moreover, an additional 9,800 inventory line items
    from the Crusader program, valued at $25.8 million, were transferred to
    the NLOS-C program. When the Army terminated the Comanche helicopter
    program, it transferred the Comanche's fly-by-wire flight control
    system technology and 70,000 line items of property to other DOD
    programs as a way to retain value for work performed as well as lower
    termination costs. Overall, the Army was able to reutilize more than 60
    percent of the Comanche's property, valued at more than $360 million.

    DOD Can Terminate a Contract and Continue Limited Work: If a contract
    is terminated, it may also be in the government's best interest to
    continue a limited amount of work on a line item of a terminated
    contract to complete technology or items for future use. For example,
    following the termination of the LCS-3, Navy officials told us that a
    significant amount of work on the gears and gas turbines, among other
    items, had been completed. As a result, the Navy decided to complete
    work on those line items of the terminated contract for use on other
    ships.

    Conclusions:

    Past experience with terminations highlights important lessons for DOD
    in making decisions to cancel individual programs as well as in
    managing its broader investment portfolio. When considering
    cancellation of individual programs, defense stakeholders have
    sometimes expressed concerns that it will cost more to terminate a
    contract than to complete it. Among the contracts that we reviewed, we
    did not find evidence to support this contention. Moreover, none of the
    DOD officials with whom we spoke identified a contract that cost more
    to terminate than complete. Accordingly, contract termination costs are
    generally not a compelling reason to continue programs or contracts
    that otherwise warrant ending. In addition, while incurred or "sunk"
    costs in programs being considered for termination may be substantial,
    they must be paid regardless of whether or not a contract is
    terminated. Therefore, the decision to terminate a contract or cancel a
    program should not be driven by sunk costs. Lastly, when a contract
    warrants termination, the decision should be made as soon as possible
    because delaying a termination almost always results in higher
    settlement costs to the government.

    From an investment portfolio perspective, terminations can be a
    valuable tool in responding to long-term fiscal imbalances as well as
    unexpected threats and other events that could constrain spending.
    While not a substitute for sound upfront investment decisions,
    terminations can create more trade space in the more than $850 billion
    that still remains in outstanding commitments in DOD's planned $1.6
    trillion investment in weapons programs. However, to make the most
    effective use of this tool, decision-makers need to be able to
    anticipate and plan for possible terminations and have a sound
    understanding of costs, benefits, and legal requirements. As a result,
    guidance on terminations developed by the military services and other
    DOD entities, should be clear, consistent, proactive, and detailed
    enough to provide the knowledge needed to use terminations as an
    investment portfolio tool.

    Recommendation:

    GAO recommends that DOD review, and as needed amend, guidance on
    terminations across the military services and DOD entities to ensure
    that termination guidance consistently identifies the conditions under
    which it is appropriate to end programs or contracts, and provides
    knowledge needed to use terminations as an investment portfolio tool.

    Agency Comments and Our Evaluation:

    DOD provided us with written comments on a draft of this report. The
    comments appear in appendix II. DOD also provided one technical
    comment, which we incorporated in this report.

    DOD concurred with our recommendation to review, and amend as needed,
    guidance on contract terminations for convenience across the military
    services and DOD. This is a positive step toward using terminations as
    an investment portfolio tool.

    We are sending copies of this report to the Secretary of Defense and
    other appropriate congressional committees. We will also make copies
    available to others upon request. In addition, the report will be
    available at no charge on GAO's Web site at [hyperlink,
    http://www.gao.gov].

    Should you or your staff have any questions about matters discussed in
    this report, please contact me at (202) 512-4841 or chaplainc@gao.gov.
    Contact points for our Offices of Congressional Relations and Public
    Affairs may be found on the last page of this report. GAO staff who
    made major contributions to this report are listed in appendix III.

    Signed by:

    Cristina Chaplain:

    Director, Acquisition and Sourcing Management:

    List of Committees:

    The Honorable Carl Levin:
    Chairman:
    The Honorable John McCain:
    Ranking Member:
    Committee on Armed Services:
    United States Senate:

    The Honorable Daniel K. Inouye:
    Chairman:
    The Honorable Ted Stevens:
    Ranking Member:
    Subcommittee on Defense:
    Committee on Appropriations:
    United States Senate:

    The Honorable Ike Skelton:
    Chairman:
    The Honorable Duncan L. Hunter:
    Ranking Member:
    Committee on Armed Services:
    House of Representatives:

    The Honorable John P. Murtha:
    Chairman:
    The Honorable C.W. Bill Young:
    Ranking Member:
    Subcommittee on Defense:
    Committee on Appropriations:
    House of Representatives:

    [End of section]

    Appendix I: Termination Costs and Settlement Amounts:

    In general, terminating a contract sooner will result in a lower
    settlement amount than terminating later, and eventually it will cost
    more to terminate than to complete a contract. How contract costs are
    spread out over the life of the contract will vary from one contract to
    another, as will termination costs. That variation in the timing and
    amount of costs could have important implications for termination
    settlement amounts. It will also determine the point at which it would
    be more cost-effective for the government to complete a contract rather
    than terminate it. This appendix will graphically illustrate these
    points.

    Components of a Termination for Convenience:

    Figure 5 illustrates the components of a settlement for a hypothetical
    contract termination for convenience. The settlement is the sum of the
    contract costs (contractor's incurred costs for work performed and fee/
    profit on that work) and termination costs. To start our discussion,
    the cost curves are depicted as linear for the sake of simplicity. This
    means that contract costs (5A) are assumed to increase at a constant
    rate over the life of the contract, and termination costs (5B) are
    assumed to be constant over the life of the contract. The settlement is
    the sum of the contract costs and termination costs as shown in figure
    5C. Changing either of the components will alter the settlement amount.

    Figure 5: Components of a Settlement:

    This figure is a combination of line graphs showing the components of a
    settlement. Time is the X axis, and Cost is the Y axis. Contract costs
    are increasing over time, termination costs are staying the same, and
    total settlement is increasing over time.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    Contract Costs:

    Figure 5 depicts linear contract cost curves. Although we do not know
    the shape of the contract cost curves for the contracts we reviewed or
    for defense contracts in general, they probably fluctuate from one
    period to the next and may resemble some form of the S curves in figure
    6.[Footnote 39] The shape of the curves in figure 6 illustrates how the
    cost of work, which presumably is driven by the amount and type of
    work, can change over the life of a contract. In figure 6, the total
    cost is the same for both curves.[Footnote 40] How that cost is spread
    out over the life of the contract can vary dramatically, as is depicted
    by the two curves in figure 6. At any given point, the contract costs
    (and ultimately the settlement) could be higher or lower depending on
    the shape of the curve. For example, if the contracts depicted in
    figure 6 were terminated early in the life of the contracts (time T1),
    contract costs would be lower under curve A than under curve B.
    Alternatively, contract costs would be higher under curve A if the
    contract were terminated later in the life of the contract (time
    T2).[Footnote 41]

    Figure 6: Two Possible Contract Cost Curves:

    This figure is a line graph showing two possible contract cost curves.
    Time is the X axis, and the Y axis represents cost.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    How Timing of a Termination May Affect the Settlement:

    Contract costs will typically be less if a contract is terminated
    sooner rather than later, but the cost of delaying a termination will
    be greater in some cases than in others. For example, as depicted in
    Figure 3, if a termination decision is delayed over a steep portion of
    the curve, the delay will result in much higher costs (i.e., delaying
    from T1 to T2 results in an increase in costs from C1 to C2). If the
    decision is delayed over a flatter portion of the curve, the delay will
    result in higher costs, but only marginally higher (i.e., delaying from
    T2 to T3 results in an increase in costs from C2 to C3). This would be
    important to know if DOD was considering a termination, but had not yet
    made a final decision.

    Figure 7: Cost Implications of Delaying a Termination Decision:

    This figure is line graph showing the cost implications of delaying a
    termination decision. Time is the X axis, and cost is the Y axis.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    Termination Costs:

    Like contract costs, it is unlikely that termination costs would be
    linear, although we do not know the shape of the termination cost
    curves for the contracts we reviewed or for defense contracts in
    general. Unlike contract costs, termination costs could go down at
    different points in the contract. Termination costs can be driven by a
    variety of factors such as negotiating with subcontractors and the cost
    of disposing of inventory. Thus, when the contractor purchases
    materials or issues a subcontract, termination costs would likely go
    up. Alternatively, if the subcontractor completes its contract before a
    termination, the prime contractor would not have to negotiate with a
    subcontractor. Thus, termination costs could increase early in the
    contract and decrease towards the end of the contract.

    In theory, if termination costs dropped enough over a short period of
    time, the settlement amount could go down, at least temporarily. A
    settlement consists of the contract costs and the termination costs.
    Contract costs always go up over time, but if they were increasing at a
    slow rate and a large subcontractor completed its work, resulting in a
    significant drop in termination costs, the sum of the two could
    actually be less than the settlement amount for the period before the
    subcontractor completed its work. However, as work continues, contract
    costs would continue to increase. Therefore, the settlement would go up
    again.

    The Break-Even Point:

    Delaying a termination decision will generally result in higher
    settlement amounts, and at some point the settlement will exceed the
    contract price. There is a break-even point at which it would cost the
    same to terminate a contract as to complete it. Terminating before that
    point would cost less than completing the contract and terminating
    after that point would cost more. Figure 8 shows that the break-even
    point is determined by contract costs, termination costs, and the
    contract price. The contract price is the amount a contractor would be
    paid if a contract is completed. At any point in the life of the
    contract, the government would have to pay for the work performed up to
    that point regardless of whether the contract is completed or
    terminated. In the event of a termination, the government would not
    have to pay for work the contractor did not perform, so the value of
    unperformed work represents the cost of completing the
    contract.[Footnote 42] We refer to the cost of completing the contract
    as the value of the remaining work. The break-even point is where the
    settlement amount is equal to the contract price. It is also where the
    value of the remaining work (the contract price less contract costs) is
    equal to termination costs. Changing the shape of the contract cost
    curve or the termination cost curve could shift when the break-even
    point occurs.

    Figure 8: The Break-Even Point:

    This figure is a line graph showing the break-even point. Work
    represent the X axis, and dollars represent the Y axis.

    [See PDF for image]

    Source: GAO analysis.

    [End of figure]

    We do not know where the break-even point occurred for the contracts we
    reviewed. However, the termination costs we observed were relatively
    low compared to the contract price (or estimated contract price). This
    suggests that the break-even point for the contracts we reviewed would
    have occurred toward the end of the contract, at least in terms of
    costs. For example, termination costs for the TSSAM contract were 6
    percent of the contract price. The break-even point would occur where
    contract costs reached 94 percent of the contract price.

    [End of section]

    Appendix II Comments from the Department of Defense:

    Office Of The Under Secretary Of Defense:
    3000 Defense Pentagon:
    Washington, DC 20301-3000:

    Acquisition Technology And Logistics:

    March 12, 2008:

    Ms. Cristina T. Chaplain:
    Director, Acquisition and Sourcing Management:
    U.S. Government Accountability Office:
    441 G Street, N.W.:
    Washington, D.C. 20548

    Dear Ms. Chaplain:

    This is the Department of Defense (DoD) response to the GAO draft
    report GAO- 08-379, `Defense Acquisitions: Termination Costs Are
    Generally Not a Compelling Reason to Continue Programs or Contracts
    That Otherwise Warrant Ending,' dated February 11, 2008, (GAO Code
    120599). Detail comments on the report recommendations are enclosed.

    Sincerely,

    Signed by:

    Shay D. Assad:
    Director, Defense Procurement and Acquisition Policy:

    Enclosure:

    As stated:

    GAO Draft Report Dated February 11, 2008 GAO-08-379 (GAO CODE 120599)

    "Defense Acquisitions: Termination Costs Are Generally Not A Compelling
    Reason To Continue Programs Or Contracts That Otherwise Warrant
    Ending":

    Department Of Defense Comments To The Gao Recommendations:

    Recommendation 1: The GAO recommends that DoD review, and as needed,
    amend guidance on terminations across the military services and DoD
    entities to ensure that termination guidance consistently identifies
    the conditions under which it is appropriate to end programs or
    contracts, and provides knowledge needed to use terminations as an
    investment portfolio tool. (Page 23/GAO Draft Report)

    DOD Response: DoD concurs with the recommendation with comment. DPAP
    will review, and amend as needed, current guidance on terminations to
    ensure that termination guidance consistently identifies the conditions
    under which it is appropriate to end programs or contracts, and
    provides knowledge needed to use terminations as an investment
    portfolio tool.

    [End of section]

    Appendix III GAO Contact and Staff Acknowledgments:

    GAO Contact:

    Cristina Chaplain (202) 512-4841 or chaplainc@gao.gov:

    Acknowledgments:

    In addition to the contact named above, Carol Dawn Petersen, Assistant
    Director; E. Brandon Booth; James Kim; Anne McDonough-Hughes; Marcus
    Lloyd Oliver; Kenneth Patton; Charles Perdue; Kelly A. Richburg; Sylvia
    Schatz; and Ann Marie Udale made key contributions to this report.

    [End of section]

    Footnotes:

    [1] At DOD, when a procuring activity decides to terminate a contract
    for convenience, although it is not required to do so, it may employ
    the assistance of the termination contracting officers at the DCMA
    Terminations Center. In the case of the Comanche helicopter, the
    termination was handled by the Army.

    [2] FAR 49.207 and 52.249-2(f).

    [3] Programs are efforts to provide a new, improved, or continuing
    material, weapon or information system, or service capability in
    response to an approved need rather than a legal agreement. DOD
    Directive 5000.1.

    [4] A cost is only allowable when the cost complies with all of the
    following requirements: that the cost is reasonable, allocable, it
    meets cost accounting standards (if applicable), the terms of the
    contract, and applicable FAR provisions. FAR 31.201-2.

    [5] For information on the use of award fees, see GAO reports GAO-07-58
    NASA Procurement: Use of Award Fees for Achieving Program Outcomes
    Should Be Improved (January 17, 2007) and GAO-06-66 Defense
    Acquisitions: DOD Has Paid Billions in Award and Incentive Fees
    Regardless of Acquisition Outcomes (December 19, 2005).

    [6] termination for convenience only has to be in the government's
    interest. See generally, FAR 52.249-2; 52.249-6.

    [7] Since default terminations involve serious consequences for a
    contractor, they are considered drastic sanctions that should be
    imposed or sustained only for good grounds and on solid evidence. The
    government bears the burden of proving the termination was justified.
    For example, see Lisbon Contractors, Inc. v. U.S., 828 F.2d 759, 765
    (Fed. Cir. 1987).

    [8] FAR subpart 49.501.

    [9] For cost-reimbursement contracts, a single clause under FAR 52.249-
    6 is used for both default and convenience terminations.

    [10] FAR Part 49.

    [11] FAR 49.102(a).

    [12] FAR 49.206-3. For commercial-item contracts, the government has no
    claim to any work in progress.

    [13] FAR 49.303-2.

    [14] FAR 49.104(i).

    [15] FAR 49.104(g).

    [16] FAR 49.206-1(a) and 49.303-1.

    [17] FAR 52.249-2 (fixed-price contracts) and FAR 52.249-6 (cost-
    reimbursement contracts).

    [18] FAR 49.105.

    [19] FAR 49.109-7(f).

    [20] Appeals for contracts with the Department of Defense are filed
    with the Armed Services Board of Contract Appeals.

    [21] FAR 52.249-2(j) and 52.249-6(j).

    [22] Comparable data for civilian agencies of contracts terminated for
    convenience are not readily available.

    [23] The terminated LCS-3 and LCS-4 ships were partial terminations, as
    they were line items under the same contracts as LCS-1 and LCS-2,
    respectively.

    [24] FAR 49.201.

    [25] For the purposes of this report, fee is for cost-reimbursement
    contracts whereas profit is for fixed-price contracts.

    [26] For the purposes of this report, incurred costs are all allowable
    costs under the contract defined under FAR �31.2 except for settlement
    expenses as described in FAR �31.205-42(g). Incurred costs would
    include the contractor's allowable costs prior to termination as well
    as reasonable costs continuing after termination.

    [27] Fixed-price contracts are not generally divided into incurred
    costs and profit. When a fixed-price contract is terminated, it is
    treated in some respects like a cost-reimbursement contract. For
    example, the contractor has to determine its incurred costs under the
    terminated contract and determine what, if any, profit it earned on its
    incurred costs. The contractor would not typically have to do this
    under a fixed-price contract that had been completed.

    [28] We use the term termination costs rather than settlement expenses
    to avoid confusion between termination settlements in general and the
    cost of settling a termination (i.e., termination costs). Our
    definition of termination costs is narrower than the FAR definition
    because we only consider those costs that are unique to a termination
    under FAR 31.205-42 (g).

    [29] The costs of preparing a settlement proposal by an attorney are
    allowable termination costs for which the contractor would be
    reimbursed.

    [30] FAR 49.207; see also FAR 52.249-2(f), which states that the total
    contract price is reduced by (1) the amount of payments previously made
    and (2) the contract price of work not terminated.

    [31] For terminations lasting more than a year, the time value of money
    would also have to be considered in determining whether it costs more
    to terminate than to complete a contract.

    [32] The FAR's Limitation of Funds clause (FAR 52.232-22) applies to
    incrementally funded cost-reimbursement contracts. It is similar to the
    Limitation of Cost clause, but limits the government's contractual
    liability to the amount of funding available on a contract, which may
    be less than the estimated contract cost.

    [33] The Limitation of Cost clause will not apply when the contractor
    could not have reasonably foreseen the cost overrun. RMI, Inc. v. U.S.
    800 F.2d 246 (Fed. Cir. 1986).

    [34] The contractor is also required to notify the government in
    writing when the contractor has reason to believe that the costs it
    will incur in the next 60 days, when added to all previously incurred
    costs, will exceed 75 percent of the estimated contract price or when
    the estimated contract cost is substantially less than previously
    estimated.

    [35] Other options include notifying the contractor in writing that (1)
    the contract will no longer be funded and the contractor should submit
    its proposal for a fee adjustment, as applicable; or (2) the government
    is considering whether to allot additional funds or to increase the
    estimated cost.

    [36] FAR 32.704(b) states, in part: Under a cost-reimbursement
    contract, the contracting officer may issue a termination notice
    without immediately increasing the funds available. Since a contractor
    is not obligated to incur costs in excess of the estimated cost in the
    contract, the contracting officer shall ensure availability of funds
    for directed actions.

    [37] However, contracting officers cannot abuse their discretion in
    failing to fund overruns, since they will be found to have breached
    their implied contractual duty of good faith and fair dealing. See
    generally, Nash Janitorial Serv., Inc., GSBCA 6390, 84-1 BCA 17,135 at
    85,370.

    [38] If a contract for commercial items is terminated for the
    government's convenience, any uncompleted inventory belongs to the
    contractor.

    [39] Contract cost curve A in figure 7 resembles the shape of the
    Actual Cost of Work Performed curves in DOD's earned value management
    literature, whereas curve B resembles total cost curves in
    microeconomic theory. One possible explanation for the difference in
    the two curves is that microeconomics generally focuses on production,
    whereas earned value management applies to a single contract that may
    cover only one phase of development or production.

    [40] In practice, the sequencing of the work and when costs are
    incurred will affect the contract cost curve. There may be a number of
    ways to structure a contract to accomplish a given amount of work, some
    that are more efficient and cost-effective than others. The most cost-
    effective way to complete a contract may not necessarily result in the
    lowest termination settlement amount.

    [41] Any contract in which costs are incurred sooner rather than later
    could potentially increase a settlement amount in the event of a
    termination. For example, multiyear contracts allow contractors to
    engage in contracts up to five years so that they can purchase more
    than one year's worth of equipment or materials from their suppliers.
    This could result in savings with regard to the total estimated cost of
    carrying out the program if the contract is completed, but may also
    result in higher incurred costs if the contract is terminated. For
    example, if the contractor bought all the materials for a 5-year
    multiyear contract at the beginning of the contract and the contract
    was terminated after the second year, the government would have to
    reimburse the contractor for 3 years' worth of materials that it no
    longer needed. By shifting costs from the fourth or fifth year to the
    first year, a multiyear contract may result in higher termination
    settlements than a series of annual contracts.

    [42] To determine whether it would cost more to terminate than to
    complete a contract, we would compare the unique costs of each course
    of action. The value of the remaining work is the unique cost of
    completing the contract, whereas termination costs are the unique costs
    of terminating a contract. For terminations lasting more than a year,
    the time value of money would also have to be considered in determining
    whether it costs more to terminate than to complete a contract.

    GAO's Mission:

    The Government Accountability Office, the audit, evaluation and
    investigative arm of Congress, exists to support Congress in meeting
    its constitutional responsibilities and to help improve the performance
    and accountability of the federal government for the American people.
    GAO examines the use of public funds; evaluates federal programs and
    policies; and provides analyses, recommendations, and other assistance
    to help Congress make informed oversight, policy, and funding
    decisions. GAO's commitment to good government is reflected in its core
    values of accountability, integrity, and reliability.

    Obtaining Copies of GAO Reports and Testimony:

    The fastest and easiest way to obtain copies of GAO documents at no
    cost is through GAO's Web site [hyperlink, http://www.gao.gov]. Each
    weekday, GAO posts newly released reports, testimony, and
    correspondence on its Web site. To have GAO e-mail you a list of newly
    posted products every afternoon, go to [hyperlink, http://www.gao.gov]
    and select "Subscribe to Updates."

    Order by Mail or Phone:

    The first copy of each printed report is free. Additional copies are $2
    each. A check or money order should be made out to the Superintendent
    of Documents. GAO also accepts VISA and Mastercard. Orders for 100 or
    more copies mailed to a single address are discounted 25 percent.
    Orders should be sent to:

    U.S. Government Accountability Office:
    441 G Street NW, Room LM:
    Washington, D.C. 20548:

    To order by Phone:
    Voice: (202) 512-6000:
    TDD: (202) 512-2537:
    Fax: (202) 512-6061:

    To Report Fraud, Waste, and Abuse in Federal Programs:

    Contact:

    Web site: [hyperlink, http://www.gao.gov/fraudnet/fraudnet.htm]:
    E-mail: fraudnet@gao.gov:
    Automated answering system: (800) 424-5454 or (202) 512-7470:

    Congressional Relations:

    Ralph Dawn, Managing Director, dawnr@gao.gov:
    (202) 512-4400:
    U.S. Government Accountability Office:
    441 G Street NW, Room 7125:
    Washington, D.C. 20548:

    Public Affairs:

    Chuck Young, Managing Director, youngc1@gao.gov:
    (202) 512-4800:
    U.S. Government Accountability Office:
    441 G Street NW, Room 7149:
    Washington, D.C. 20548:

    *** End of document. ***