High Risk Series: Defense Contract Management (Letter Report, 02/95,
GAO/HR-95-3).

In 1990, GAO began a special effort to identify federal programs at high
risk of waste, fraud, abuse, and mismanagement.  GAO issued a series of
reports in December 1992 on the fundamental causes of the problems in
the high-risk areas.  This report on defense contract management is part
of the second series that updates the status of this high-risk area.
Readers have the following three options in ordering the high-risk
series: (1) request any of the individual reports in the series,
including the Overview (HR-95-1), the Guide (HR-95-2), or any of the 10
issue area reports; (2) request the Overview and the Guide as a package
(HR-95-21SET); or (3) request the entire series as a package
(HR-95-20SET).

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

 REPORTNUM:  HR-95-3
     TITLE:  High Risk Series: Defense Contract Management
      DATE:  02/01/95
   SUBJECT:  Risk management
             Department of Defense contractors
             Fraud
             Erroneous payments
             Defense contracts
             Contractor payments
             Questionable payments
             Contract costs
             Defense cost control
             Program abuses
IDENTIFIER:  High Risk Series 1995
             
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Cover
================================================================ COVER


High-Risk Series

February 1995

DEFENSE CONTRACT MANAGEMENT

GAO/HR-95-3

Defense Contract Management


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

  DOD -
  DCAA -
  DFAS -
  FAR -

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



February 1995

The President of the Senate
The Speaker of the House of Representatives

In 1990, the General Accounting Office began a special effort to
review and report on the federal program areas we considered high
risk because they were especially vulnerable to waste, fraud, abuse,
and mismanagement.  This effort, which has been strongly supported by
the Senate Committee on Governmental Affairs and the House Committee
on Government Reform and Oversight, brought much needed focus to
problems that were costing the government billions of dollars. 

In December 1992, we issued a series of reports on the fundamental
causes of problems in designated high-risk areas.  We are updating
the status of our high-risk program in this second series.  Our
Overview report (GAO/HR-95-1) discusses progress made in many areas,
stresses the need for further action to address remaining critical
problems, and introduces newly designated high-risk areas.  This
second series also includes a Quick Reference Guide (GAO/HR-95-2)
that covers all 18 high-risk areas we have tracked over the past few
years, and separate reports that detail continuing significant
problems and resolution actions needed in 10 areas. 

This report discusses our findings and recommendations on the
significant contracting risks faced by the Department of Defense.  We
conclude that despite reduced levels of defective pricing since we
issued our last high-risk series report, significant contracting
risks remain.  Defense must continue to focus on correcting
long-standing contractor cost estimating problems.  Defense
contractors also need to improve their procedures for identifying and
excluding unallowable costs from overhead submissions.  Further,
Defense must immediately address very serious weaknesses in its
financial controls.  These weaknesses contribute to sizable and
widespread overpayments to defense contractors and create the
opportunity for fraudulent activities. 

Copies of this report series are being sent to the President, the
Republican and Democratic leadership of the Congress, congressional
committee chairs and ranking minority members, all other members of
the Congress, the Director of the Office of Management and Budget,
and the Secretary of Defense. 

Charles A.  Bowsher
Comptroller General
of the United States


OVERVIEW
============================================================ Chapter 0

Reported defective contract pricing, an issue discussed in our 1992
high-risk series report, has declined significantly from a near-term
high of $919.3 million in fiscal year 1990 to $125.5 million in
fiscal year 1993--a decline of about 86 percent.  At the same time,
defense contractors' performance in correcting significant
cost-estimating system deficiencies, which is key to sustaining a
reduced risk of defective pricing, has been mixed. 

Our audit work has also identified the following additional defense
contracting issues as areas of high risk: 

Serious DOD financial control weaknesses have resulted in large and
numerous erroneous and in some cases, fraudulent payments to defense
contractors.  During a 6-month period in fiscal year 1993 defense
contractors returned to the government $751 million, and in fiscal
year 1994, they returned $957 million, most of which appears to have
been overpayments that were detected by the contractors. 

Weaknesses in contractor procedures for identifying and excluding
unallowable costs from overhead submissions have contributed to DOD
reimbursing contractors for unallowable overhead costs.  During
fiscal years 1991-1993, DOD auditors questioned about $3 billion in
contractors' overhead charges. 

The current emphasis on acquisition reform and the recently passed
Federal Acquisition Streamlining Act of 1994 are positive steps
toward strengthening the acquisition system.  However, these actions
can be successful only by ensuring the integrity and fairness of the
procurement and contracting processes and properly protecting the
government's and the taxpayers' interests. 


BACKGROUND
============================================================ Chapter 1

With the end of the Cold War, the nation began to reassess the
threats to U.S.  security interests and restructure its military
capabilities.  While the reassessment continues, two key facts have
emerged: 

U.S.  military forces and the defense industrial base that supports
them have been significantly reduced. 

The economic dimension of national security is commanding increased
attention. 

These facts have resulted in diverse legislative and executive branch
actions--all aimed at preserving a healthy and efficient defense
industrial base and enhancing U.S.  competitiveness.  Among the more
significant actions are efforts to reform defense acquisition, to
encourage the use of commercial products and dual-use technologies,
to convert defense firms to commercial work, and to promote defense
exports. 

Consistent with the reduced threat and related downsizing, DOD
reduced its contracting.  In fiscal year 1991, DOD reported
contracting for almost $150 billion for contractors' goods and
services--nearly 2-1/2 times the combined purchases of all federal
civilian agencies.  Although still significant, the value of DOD
contracts was reduced to around $121 billion in fiscal year 1993. 


REDUCED LEVEL OF REPORTED
DEFECTIVE PRICING
============================================================ Chapter 2

Historically, a principal concern in other than fully competitive
procurements has been to ensure that contractors' proposed prices are
fair and reasonable.  Because of the nature of the contracting
process, each party attempts to protect its own constituents'
interests.  The contractor supports its shareholders by attempting to
maximize profits, while the government protects the taxpayers by
trying to ensure that contractors provide quality products at fair
and reasonable prices. 

In our 1992 high-risk series report, we discussed the risks
associated with defectively priced contracts\1 and identified
necessary actions.  We pointed out that roughly one of every three
audited contracts had been identified as defectively priced, and, as
a result, the government paid excess costs in billions of dollars. 
For example, during fiscal years 1987-91, the Defense Contract Audit
Agency (DCAA) reported defective prices totaling $3.67 billion. 
Also, we discussed the importance of contractors' using sound
cost-estimating systems to ensure that their prices are based on
complete, accurate, and current data and the need for DOD management
attention to this area. 

Since that time, in part as a result of reduced DOD contracting
activity, the amount of reported defective pricing has declined
significantly.  For example, from fiscal year 1990 to fiscal year
1993, defective pricing reported by DCAA declined by about 86
percent, from $919.3 million to $125.5 million.  While this reduction
suggests a reduced level of risk for defective pricing, our recent
work continues to show mixed results in terms of contractors'
correcting significant deficiencies in their cost-estimating systems. 
Addressing significant contractor cost-estimating deficiencies
continues to require DOD management attention. 


--------------------
\1 Defective pricing occurs when a contract price is increased
because the contractor has not provided complete, accurate, and
current cost or pricing data.  If this happens, the government can
reduce the contract price. 


      SIGNIFICANT COST-ESTIMATING
      DEFICIENCIES NEED CONTINUED
      ATTENTION
-------------------------------------------------------- Chapter 2:0.1

Cost-estimating systems that produce reliable price proposals are a
key safeguard to obtaining fair and reasonable contract prices.  DOD
administrative contracting officers are responsible for determining
the adequacy of the contractors' estimating systems and, if the
estimating systems are deficient, for requiring correction. 

We recently reviewed the 30 DOD contractors that DCAA assessed as
having high-risk cost-estimating systems.  According to DCAA, these
contractors had a total of 117 significant deficiencies in their
cost-estimating systems.  We found that contractors' performance in
correcting these deficiencies has been mixed.  Although 19 of the 30
contractors had corrected or potentially corrected\2 all their
significant deficiencies, the remaining 11 contractors had
significant uncorrected deficiencies that had been outstanding an
average of 3.8 years.  The failure to correct these deficiencies in a
timely manner creates a variety of problems for DOD, including
increased costs and delays in contract awards. 

We further found that although some significant estimating
deficiencies have been outstanding for years, contracting officers
have been reluctant to use the strong sanctions provided by the
Federal Acquisition Regulation (FAR).  The contracting officers
responsible for the contractors with significant uncorrected
cost-estimating system deficiencies used a variety of approaches to
get corrective action in addition to providing the contractors with
DCAA's estimating system audit report and requesting that the
deficiencies be corrected.  However, no contracting officers took the
more stringent measures allowed under regulations--reducing or
suspending progress payments or recommending nonaward of potential
contracts.  For example, in September 1989, one contractor was
reported by DCAA to have three significant cost-estimating system
deficiencies:  (1) not considering historically negotiated price
reductions when estimating subcontract prices, (2) not providing
adequate cost or pricing data to support estimated computer costs
transferred from another division, and (3) not having adequate
procedures to ensure that contractor estimators used appropriate cost
or pricing data for estimating material and subcontract costs. 

In October 1989, the contractor submitted its corrective action plan
that showed the deficiencies would be corrected by February 1990. 
However, the contractor did not resolve these deficiencies.  A joint
government/contractor team, established by the contracting officer in
February 1991, was also unsuccessful in resolving the deficiencies. 
In July 1992, the contracting officer notified the contractor of the
government's intent to disapprove the contractor's estimating system. 
According to the contracting officer, he did not, however, disapprove
the system because (1) the contractor was the sole source of the
items under contract and the government could not award the contract
to anyone else and (2) one deficiency was in litigation.  As of
January 31, 1994, more than 4 years after the deficiencies were first
reported, the three deficiencies remained uncorrected (one of the
three deficiencies was in litigation). 

When significant uncorrected estimating systems deficiencies exist,
DOD officials must take extra steps to protect the government's
interests.  The extra steps DOD takes are frequently time-consuming
and costly.  For example, in December 1991, DCAA reported that a
certain contractor had five significant estimating system
deficiencies.  DCAA first reported these deficiencies in September
1990.  The deficiencies remained uncorrected when, in June 1992, the
contractor submitted a $550 million proposal to DOD that was based on
costs generated by the estimating system. 

After a substantial effort, DCAA and Army officials involved in the
negotiation said they identified numerous errors in the proposal that
would have significantly increased the government's costs.  For
example, DCAA's audit of the proposal found it to be unacceptable as
a basis for negotiating a fair and reasonable price.  When the
contractor resubmitted data, DCAA found much of it still
unacceptable.  DCAA officials told us that auditing the contractor's
proposal was time-consuming because they were not sure of the quality
of the data submitted and needed to verify nearly all the information
in the proposal.  As a result, DCAA officials said they used more
audit resources than normally would have been required. 

Army contracting officials said they also invested considerable
effort in obtaining and reviewing information from the contractor. 
The Army's contracting officer said the Army submitted about 100
requests to the contractor for additional information, more than
twice the normal number of requests.  Army contracting officials said
that, because they did not trust the contractor's estimating system,
reviewing the data the contractor provided was time-consuming. 


--------------------
\2 We considered deficiencies to be potentially corrected when a
contractor reported that the deficiency was corrected, but the
contracting officer had not yet determined the adequacy of the
contractor's actions. 


CONTROLS OVER UNALLOWABLE OVERHEAD
COSTS
============================================================ Chapter 3

When defense contractors bill the government for services rendered,
they charge not only for the direct costs they incur but also for a
portion of their overhead costs.  However, not all costs incurred by
defense contractors can be charged to government contracts. 

The FAR contract cost principles provide the basic framework for
allowable and unallowable costs.  The FAR expressly states that the
costs of such items as alcohol, entertainment, legislative lobbying,
and donations are unallowable charges to government contracts.  In
other cases, the regulation is more general and does not expressly
identify categories of costs as unallowable, but it uses the criteria
of reasonableness and allocability in determining the nature and
amount of costs that are allowable. 

The regulation also clearly spells out that the contractor is
responsible for establishing systems to identify and exclude
unallowable costs from its overhead cost submissions.  Unfortunately,
these systems do not work as well as they should.  Over the years, we
and DCAA have questioned the allowability of billions of dollars of
costs included in contractor overhead submissions. 

Our past work has shown that the inclusion of unallowable costs in
contractor overhead submissions resulted in large measure from
weaknesses in contractor procedures for screening for unallowable
costs.  Contractor procedures need to be improved.  Also contributing
to the inclusion of unallowable costs in contractor overhead
submissions are ambiguities in the FAR and insufficient transaction
testing by DCAA.  In this regard, the recently enacted Federal
Acquisition Streamlining Act of 1994 took a positive step to
eliminate the ambiguities in the regulation's cost principles
regarding the allowability of certain contractor costs.  While DCAA
needs to audit contracts more thoroughly than it has in the past, it
may have difficulty doing this given the breadth of its workload and
recent and planned staff reductions. 


WEAK FINANCIAL CONTROLS OVER DOD
CONTRACT PAYMENTS
============================================================ Chapter 4

Sound financial controls are critical for effectively managing
contracts at DOD and for ensuring that taxpayers' funds are disbursed
properly.  A dramatic indicator of the adverse effects of poor
controls over the disbursement process is the dollar value of
payments returned to the government by defense contractors.  Our work
has shown that during a 6-month period in fiscal year 1993, the
Defense Finance and Accounting Service (DFAS) in Columbus, Ohio--a
principal DOD contract-paying activity--processed $751 million in
checks from defense contractors.  Our examination of $392 million of
the $751 million returned by contractors disclosed that about $305
million, or about 78 percent, represented overpayments by the
government.  During fiscal year 1994, contractors returned an
additional $957 million.  DFAS-Columbus overpaid contractors
principally because it (1) paid invoices without considering previous
progress payments, or (2) made duplicate payments. 

Underscoring our concern about the amount of overpayments is the fact
that the majority of the overpayments we examined were detected by
contractors, rather than by DFAS through its controls.  If the
government must rely on contractors rather than its own controls to
detect and collect overpayments, the risk is greater that losses will
result from undetected, or unreturned, overpayments. 

The DFAS-Columbus collection process also did not ensure prompt
return of overpayments identified and reported by contractors.  In
some cases, contractors planned to return overpayments but were told
to hold them until the contracts could be reconciled and demand
letters issued.  The interest costs associated with these
overpayments, even when they are returned, can be significant.  To
illustrate, for about $240 million in returned overpayments for which
we could determine the date the disbursement was made, we estimated
the interest costs were about $2.3 million. 

To determine the extent of the overpayment problem, we examined nine
defense contractors' records.  We found that the magnitude of
unreturned overpayments and uncorrected underpayments reflects a
major problem requiring DOD's immediate attention.  The nine
contractor locations had unresolved payment discrepancies totaling
about $118 million--$30.3 million in overpayments and $87.7 million
in underpayments.  These overpayments and underpayments result in
significant unnecessary costs to the government.  At current interest
rates, the overpayments could cost the government about $5,800 per
day.  Because the Prompt Payment Act requires DOD to pay interest on
valid invoices that are paid late, the underpayments we identified
could cost DOD about $16,800 per day. 

Each contractor had returned some overpayments, but the nine
contractors were retaining some overpayments.  Contractor officials
gave several reasons for not returning overpayments; however, none of
the reasons appeared to justify not returning overpayments or
delaying the resolution of discrepancies.  While the DFAS-Columbus
office made most of the payments, other DFAS-paying offices had also
made payments; some discrepancies had been outstanding for several
years.  DOD officials had been notified of some discrepancies but had
not taken corrective action.  Neither DOD nor the contractors
appeared to be aggressively pursuing resolution of payment
discrepancies. 

DOD is currently considering ways to strengthen its existing internal
control procedures to prevent overpayments and to more rapidly detect
such payments when they occur.  Also, initiatives are under way to
reform and streamline the complex regulatory policies and procedures
that affect contract payments.  Changes being considered include
redesigning the progress payment process; improving the quality of
contract preparation; revising a number of contract, payment, and
debt collection regulations; and increasing the use of electronic
data interchange for delivery, acceptance, payment, and review. 

In addition, DFAS-Columbus has initiated a number of actions to
correct persistent overpayment errors.  These include (1) stricter
adherence to operating procedures that previously had not been
followed, (2) improved maintenance of the progress payment master
files, (3) increased management and supervisory attention to errors
and their causes, (4) increased training on how to address specific
payment problems, and (5) computer systems changes such as rejecting
large dollar payments if progress payments are not liquidated. 

Because of the large dollar amounts at risk, DOD should view the need
for corrective actions in this area with an increased sense of
urgency. 


      WEAK CONTRACT CONTROLS
      PERMIT FRAUD
-------------------------------------------------------- Chapter 4:0.1

Breakdowns in payment controls have also contributed to fraudulent
payments.  A case in point concerns $3 million in false claims made
by a former DOD supply officer.  While the overall amount of the
fraudulent payments in this case is certainly disturbing in itself,
other circumstances surrounding this case may provide even more
insight into the poor conditions of a key portion of DOD's internal
control structure. 

In this case, a former Navy supply officer, working primarily from
outside Navy and DOD financial organizations, established a
fictitious contracting company and received payments for over a
hundred bogus invoices.  Navy personnel discovered his illegal
activities after he submitted several invoices for large amounts for
parts purportedly delivered to a decommissioned vessel.  Had the
invoices not been for large sums for parts on a decommissioned
vessel, he might have been able to continue to carry out his scheme. 

The former supply officer carried out his illegal activities for
almost 4 years because controls were inadequate to ensure that (1)
parts were ordered using authorized purchase orders, (2) parts were
accepted by authorized Navy personnel, and (3) payment requests were
valid.  Also, the Navy did not match individual disbursements with
related obligations, another control procedure that could have
triggered an investigation leading to disclosure of the fraud. 

The relatively unsophisticated method used to perpetrate this fraud
illustrates just how weak DOD's disbursement controls are.  Also, the
fact that this and other cases of fraud were discovered by chance and
not through internal controls raises the possibility that other
schemes may be ongoing and undetected. 


      BILLIONS OF DOLLARS OF
      CONTRACT DISBURSEMENTS
      CANNOT BE PROPERLY MATCHED
      TO OBLIGATIONS
-------------------------------------------------------- Chapter 4:0.2

Matching disbursements with recorded obligations is an important
control for ensuring that agency funds are used for the purposes and
limitations specified by the Congress.  Without such matching, there
is a substantial risk that (1) fraudulent or erroneous payments may
be made without being detected and (2) cumulative amounts of
disbursements may exceed appropriated amounts and other legal limits. 

Long-standing problems have plagued DOD's efforts to properly match
disbursements with obligations.  For example, in October 1994, we
reported that as of June 30, 1994, DOD's records contained at least
$24.8 billion of problem disbursements. 

Over the past year, DOD has taken steps to address its long-standing
disbursement problems.  However, correcting these problems will not
be an easy task.  As reported for many years, these problems are
attributable to DOD's failure to practice sound financial management
and the extremely poor quality of its automated contract pay and
accounting systems.  Unless accounting discipline and internal
control practices are emphasized and enforced in the short term, DOD
problem disbursements may be generated as fast as DOD can resolve
them.  In the long term, DOD must improve payment and accounting
systems and internal control features to avoid making payments that
cannot readily be matched to corresponding obligations. 


FURTHER ACTION NEEDED
============================================================ Chapter 5

While the level of reported defective pricing has been reduced with
the decline in defense contracting, contractor cost-estimating
systems remain an area of concern which requires continued DOD
management attention.  In addition, contract management risks exist
because of (1) inadequate contractor procedures for identifying and
excluding unallowable costs from overhead submissions and (2) poor
DOD financial controls over payments to contractors. 

To gain control over these troublesome problems, DOD needs to
continue to emphasize to contractors the importance of expeditiously
correcting deficiencies in their cost-estimating systems.  DOD should
persist in determining why long-standing deficiencies have not been
corrected.  It should also establish specific time frames for
contracting officers as to when to seek guidance about using more
severe remedies that are already available and when higher level
management must become involved in resolving significant
deficiencies. 

Defense contractors and DCAA share responsibility for unallowable
contract costs.  While contractors need to strengthen their controls
to ensure that they do not charge unallowable contract costs, DCAA
needs to improve its audits of contractors' overhead submissions.  We
acknowledge, however, that DCAA may have difficulty increasing audits
given the scope of its workload and recent and planned staff
reductions. 

Top-level DOD management must also intensify its commitment to
resolve contract payment disbursement problems.  In the short term,
DOD's efforts, including its efforts to research problem disbursement
transactions and correct errors, will likely reduce the amount of
erroneous and fraudulent payments and disbursements not properly
matched to obligations.  However, DOD will not adequately resolve its
disbursement problems until it (1) corrects weaknesses in control
procedures that allow problem disbursements to occur and (2) improves
its contract pay and accounting systems. 


RELATED GAO PRODUCTS
============================================================ Chapter 6

Financial Management:  Status of Defense Efforts to Correct
Disbursement Problems (GAO/AIMD-95-7, Oct.  5, 1994). 

DOD Procurement:  Overpayments and Underpayments at Selected
Contractors Show Major Problem (GAO/NSIAD-94-245, Aug.  5, 1994). 

Contract Pricing:  DOD Management of Contractors With High Risk
Cost-Estimating Systems (GAO/NSIAD-94-153, July 19, 1994). 

Financial Management:  Financial Control and System Weaknesses
Continue to Waste DOD Resources and Undermine Operations
(GAO/T-AIMD/NSIAD-94-154, Apr.  12, 1994). 

Contract Pricing:  Reasons for the Decline in Reported Defective
Pricing (GAO/NSIAD-94-144BR, Apr.  11, 1994). 

Overhead Costs:  Unallowable and Questionable Costs Charged by
E-Systems, Inc.  (GAO/NSIAD-94-113, Mar.  28, 1994). 

DOD Procurement:  Millions in Overpayments Returned by DOD
Contractors (GAO/NSIAD-94-106, Mar.  14, 1994). 

Overhead Costs:  Unallowable and Questionable Costs Charged by
Government Contractors (GAO/T-NSIAD-94-132, Mar.  3, 1994). 

Overhead Costs:  Unallowable and Questionable Costs Charged by
McDonnell Douglas Corporation (GAO/T-NSIAD-94-60.  Oct.  13, 1993). 

Financial Management:  DOD Has Not Responded Effectively to Serious,
Long-standing Problems (GAO/T-AIMD-93-1, July 1, 1993). 

Financial Management:  Navy Records Contain Billions of Dollars in
Unmatched Disbursements (GAO/AFMD-93-21, June 9, 1993). 

High-Risk Series:  Defense Contract Pricing (GAO/HR-93-8, Dec. 
1992). 


1995 HIGH-RISK SERIES
============================================================ Chapter 7

An Overview (GAO/HR-95-1)

Quick Reference Guide (GAO/HR-95-2)

Defense Contract Management (GAO/HR-95-3)

Defense Weapons Systems Acquisition (GAO/HR-95-4)

Defense Inventory Management (GAO/HR-95-5)

Internal Revenue Service Receivables (GAO/HR-95-6)

Asset Forfeiture Programs (GAO/HR-95-7)

Medicare Claims (GAO/HR-95-8)

Farm Loan Programs (GAO/HR-95-9)

Student Financial Aid (GAO/HR-95-10)

Department of Housing and Urban Development (GAO/HR-95-11)

Superfund Program Management (GAO/HR-95-12)

The entire series of 12 high-risk reports can be ordered by using the
order number GAO/HR-95-20SET. 

