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					 

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GAO-08-379

   

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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 nationï¿½s long-term fiscal imbalances will likely make DODï¿½s $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 DODï¿½s 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 [email protected]. 

[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 Crusaderï¿½an automated, next- generation field artillery systemï¿½was 
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 itemsï¿½valued at more than $150 millionï¿½from the 
Crusader to create the Non-Line-of-Sight Cannon program as well as an 
additional 9,800 inventory line itemsï¿½valued at $25.8 millionï¿½to 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 Companyï¿½Marietta; 
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 DODï¿½s 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 programï¿½s 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 Comancheï¿½s 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 [email protected]. 
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 [email protected]: 

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 ï¿½31.2 except for settlement 
expenses as described in FAR ï¿½31.205-42(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. 

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