Defense Acquisitions: Prices of Marine Corps Spare Parts Have Increased
(Letter Report, 07/31/2000, GAO/NSIAD-00-123).

Pursuant to a congressional request, GAO provided information on the
increasing prices of Marine Corps spare parts, focusing on: (1) changes
in the prices of reparable parts compared with the prices of similar
items in the private sector and the reasons for the price changes; and
(2) the accuracy of prices set by the Marine Corps.

GAO noted that: (1) prices of the 703 parts GAO examined increased by an
average of about 14 percent over the 4-year period from fiscal year 1995
through 1999, while prices for similar items sold in the private sector
dropped by 0.2 percent over the same period; (2) prices for these 703
parts fluctuated during this 4-year period, dropping by about 10 percent
during the first 2 years and increasing by about 27 percent during the
last 2 years; (3) prices of the 313 parts sold to customers followed the
same pricing pattern; (4) the major cause of the sharp price increase
during the latter years was increases in surcharge rates; (5) the cost
of procuring the parts from suppliers influenced the price of only 26
parts; (6) the Marine Corps did not follow the Department of Defense
pricing regulations in setting prices and, as a result, the prices of
most parts sold to Marine Corps customers were not correct; (7) in
particular, the approach used to adjust prices of repaired parts from
year to year was not consistent with Defense regulations; (8) the Marine
Corps' approach led to wider price fluctuations than the approach called
for in Defense pricing regulations; (9) moreover, prices for many parts
were higher than they would have been had repair costs been used to set
prices; (10) mathematical and computer program errors were also made;
(11) these problems contributed to the Marine Corps having an
accumulated gain of about $48 million from the sale of spare parts at
the end of fiscal year 1999; and (12) Defense policy requires revolving
funds to operate with the long-term objective of breaking even.

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

 REPORTNUM:  NSIAD-00-123
     TITLE:  Defense Acquisitions: Prices of Marine Corps Spare Parts
	     Have Increased
      DATE:  07/31/2000
   SUBJECT:  Military procurement
	     Prices and pricing
	     Spare parts
	     Comparative analysis

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GAO/NSIAD-00-123

Appendix I: Scope and Methodology

20

Appendix II: Marine Corps Surcharge and Price
Change Rates

22

Appendix III: Average Percentage Changes in Standard Prices,
Fiscal Years 1995-99 and 1997-99

29

Appendix IV: Marine Corps Sales, by Federal Supply Group,
From October 1, 1996, Through April 25, 1999, and
Average Percentage Price Increases in Fiscal Years
1997-99

30

Appendix V: Comments From the Department of Defense

31

Appendix VI: GAO Contacts and Staff Acknowledgments

35

Table 1: Marine Corps Surcharge and Price Change Rates 7

Table 2: Elements Used to Compute Marine Corps Surcharge
Rates, Fiscal Years 1997-00 23

Table 3: Estimated Costs and Projected Sales, Fiscal Years
1997-98 24

Table 4: Estimated Costs and Projected Sales, Fiscal Years
1998-99 25

Table 5: Estimated Costs and Projected Sales, Fiscal Years
1999-2000 26

Table 6: Customer Change Rates, Fiscal Years 1997-00 27

Figure 1: Marine Corps Logistics Base, Albany, Georgia 6

Figure 2: Changes in Marine Corps Prices Compared with
Changes in Prices of Similar Items in the Private Sector 8

Figure 3: Effect of Annual Price Adjustments on the Price of a Communication
Terminal 9

Figure 4: Example of Setting Part Prices 12

Figure 5: Reported Repair Costs as a Percentage of Standard Prices 13

Figure 6: Accumulated Gains by Fiscal Year 15

National Security and
International Affairs Division

B-281206

July 26, 2000

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

Because of concerns by military commands about increasing prices for spare
parts, you requested that we examine spare part prices to determine whether
they were increasing at a rate faster than inflation and the extent to which
surcharges, suppliers' prices, and other factors contributed to price
increases.

This is the first in a series of reports examining price trends of spare
parts managed by the military services. This report contains information on
reparable spare parts1 the Marine Corps uses to maintain ground combat and
support equipment such as vehicles, radars, and radio receivers.
Specifically, it addresses (1) changes in the prices of reparable parts
compared with the prices of similar items in the private sector and the
reasons for the price changes and (2) the accuracy of prices set by the
Marine Corps.

Defense pricing policy requires the Marine Corps to establish prices for
spare parts it manages at the beginning of each fiscal year. The Marine
Corps manages its reparable spare parts under a revolving stock fund and
charges its field units and repair facilities (referred to as customers) for
parts provided. A surcharge is added to the cost of the parts to cover the
costs of managing, storing, and distributing the parts.

To determine whether prices of Marine Corps spare parts were increasing at a
rate faster than inflation, we examined the price trend for the 703
different parts the Marine Corps managed from fiscal year 1995 through
1999.2 Of these 703 parts, the Marine Corps sold 313 to customers during
fiscal years 1997-99. We reviewed the prices of these 313 parts to determine
the reasons for price changes. To review spare part prices, we examined the
procedures and methods the Marine Corps used to compute prices. Specific
information on our scope and methodology is in appendix I.

Prices of the 703 parts we examined increased by an average of about
14 percent over the 4-year period from fiscal year 1995 through 1999, while
prices for similar items sold in the private sector dropped by 0.2 percent
over the same period. Prices for these 703 parts fluctuated during this
4-year period, dropping by about 10 percent during the first 2 years and
increasing by about 27 percent during the last 2 years. Prices of the 313
parts sold to customers followed the same pricing pattern. The major cause
of the sharp price increase during the latter years was increases in
surcharge rates. The cost of procuring the parts from suppliers influenced
the price of only 26 parts.

The Marine Corps did not follow Defense pricing regulations in setting
prices and, as a result, the prices of most parts sold to Marine Corps
customers were not correct. In particular, the approach used to adjust
prices of repaired parts from year to year was not consistent with Defense
regulations. The Marine Corps' approach led to wider price fluctuations than
the approach called for in Defense pricing regulations. Moreover, prices for
many parts were higher than they would have been had repair costs been used
to set prices. Mathematical and computer program errors were also made.
These problems contributed to the Marine Corps having an accumulated gain of
about $48 million from the sale of spare parts at the end of fiscal year
1999. Defense policy requires revolving funds to operate with the long-term
objective of breaking even.

The Marine Corps has initiated actions to correct its method for setting
prices. We are recommending that the Marine Corps prepare an action plan for
completing corrections so that changes will be incorporated in fiscal year
2001 prices. In written comments on a draft of this report, the Department
generally agreed with our findings and recommendation but took exception to
the use of the term "profit" in our draft report to describe the Marine
Corps' accumulated gain from supply operations. To avoid any
misunderstanding, we substituted the term "accumulated gain" for "profit" to
describe the position of the fund.

The Marine Corps stocks different types of reparable spare parts, ranging
from diesel engines to electronic components. Each year the Marine Corps
purchases a few new parts from suppliers but obtains most of the parts
needed to support its operations by refurbishing broken ones that customers
turn in for repair. Between July 1, 1996, and June 30, 1998, for example,
the Marine Corps purchased only 61 different parts from suppliers. These
parts included items such as circuit card assemblies, diesel engines, and
radio frequency amplifiers.

In the late 1980s, the Department of Defense concluded that the military
services should manage reparable spare parts using revolving stock funds.
The primary goal of a revolving fund is to focus attention on the total
costs of operations in order to provide goods and services at the lowest
costs. A revolving fund is intended to operate much like a commercial
business, procuring inventory to satisfy customer needs, stocking it until
sold, and using the cash from sales to pay for all associated operating
costs, including procurement of replacement inventory. Generally, a
revolving fund relies on sale revenues to finance its operations and is not
intended to make a profit over the long term.

In fiscal year 1994, the Marine Corps placed 890 different parts--less than
one-third of the parts it was managing at that time--into the stock fund and
started charging its customers for the parts. The Marine Corps placed the
remainder of its reparable parts into the stock fund in fiscal year 1998 and
began charging customers for them in fiscal year 2000. In fiscal year 1999,
the Marine Corps was managing 3,200 different reparable spare parts with a
total inventory value of $480 million. These parts are stored in depots3
until a Marine Corps customer needs them. Figure 1 shows parts in storage at
the Albany, Georgia, depot.

Source: Marine Corps.

The Marine Corps establishes a price--called a standard price--for each of
its reparable spare parts and uses these prices to charge customers for
parts they order. Defense pricing procedures require that standard prices be
set by taking the most recent purchase price and adding a surcharge. The
surcharge is designed to recoup supply management costs such as salaries,
obsolescence, and storage expenses. The Marine Corps revises standard prices
annually by using one of two approaches. If a part has been procured
recently,4 the Marine Corps applies a surcharge to the purchase price to
establish a standard price for the following fiscal year. If a part has not
been procured recently, the Marine Corps revises the price of the part by
applying a price change rate5 to the current standard price of the part.
Both the surcharge and price change rate vary from year to year (see
table 1).

 Fiscal year Surcharge rate  Price change rate
 1995        44.01           0.70
 1996        39.50           -9.10
 1997        24.59           -10.69
 1998        43.75           19.17
 1999        45.83           3.61

Source: Marine Corps.

Appendix II contains a discussion of these rates, including how they are
computed.

When a customer orders a part, the Marine Corps charges the standard price
if the customer does not return a broken part that can be economically
repaired. When a broken part is returned, however, the Marine Corps charges
the customer an exchange price, which is less than the standard price. Most
Marine Corps sales are made at the lower exchange prices, which are set
using 57 percent of a part's standard price.

Prices of the parts we examined fluctuated during the 4-year period from
fiscal year 1995 through 1999, dropping during the first 2 years and
increasing sharply during the last 2 years. Prices for the 313 parts sold to
customers followed the same pricing pattern. Increases in surcharge rates
caused the major part of the sharp price increase during the latter 2 years.
These surcharges recover the costs of managing, storing, and distributing
parts.

1995-99

From fiscal year 1995 through 1999, prices of the 703 parts we examined
increased by an average of about 14 percent, or about 3 to 4 percent
annually. The producer price index we used showed that prices for similar
items sold in the private sector dropped by about 0.2 percent during the

same period.6 Figure 2 compares the changes in the prices of these 703 parts
with changes in the prices of similar items in the private sector.

Source: our analysis of Marine Corps data.

Prices of the 703 parts fluctuated considerably during the 4-year period,
dropping by about 10 percent during the first 2 years and increasing by
about 27 percent during the last 2 years. Appendix III shows the average
percentage price change for these 703 parts.

The Marine Corps sold 313 of the 703 parts for $38 million during fiscal
years 1997-99. The price changes for these parts followed the same pattern
as the price changes for all 703 parts--dropping during the first 2 years
and increasing during the last 2 years. Appendix IV shows the average price
change for the 313 parts.

Marine Corps customers were affected far more by price increases resulting
from changes in surcharge rates than by changes in procurement prices. Of
the 313 parts sold to Marine Corps customers, prices for 273 of these parts
increased primarily because of the price change rates applied to standard
prices. The price change rate is derived from the same elements used to
compute the surcharge and is essentially the difference between the current
and prior year's surcharge rate. The 273 parts accounted for about 88
percent of the $38 million in sales to Marine Corps customers.

The Marine Corps' pricing of a communication terminal illustrates how the
price of that part increased between fiscal years 1997-99 as a result of
increases in the price change rates (see fig. 3).

Source: our analysis of Marine Corps data.

As shown by figure 3, the price of the communication terminal increased from
$11,810 in fiscal year 1997 to $14,581 in fiscal year 1999, an increase of
$2,771. To compute the fiscal year 1998 price, the Marine Corps applied the
19.17-percent price change rate to the part's fiscal year 1997 price. To
compute the fiscal year 1999 price, the Marine Corps applied the
3.61-percent price change rate to the part's fiscal year 1998 price. In
total, the Marine Corps increased the price of this part by about 23 percent
by applying the price change rates for fiscal years 1998 and 1999 as shown
in table 1. The Marine Corps increased the prices of the other 272 parts in
the same manner.

Prices for the remaining 26 parts7 changed in response to changes in the
cost of procuring the parts from suppliers. Prices for these parts increased
by an average of 68 percent in fiscal years 1997-99.

Defense financial management procedures require the military services to
calculate standard prices for spare parts annually. These procedures
stipulate that the revenue from sales is not to exceed the costs of
supplying the parts over the long term. However, the Marine Corps has not
followed Defense procedures in calculating spare part prices, resulting in
prices that were higher or lower than they should have been. Prices for some
spare parts were unrealistic because the Marine Corps did not compute prices
on the basis of actual repair costs.8 In addition, some prices computed by
the Marine Corps were incorrect because of mathematical mistakes, computer
program flaws, or other errors. These conditions contributed to the Marine
Corps reporting an accumulated gain of about $48 million at the end of
fiscal year 1999 from the sale of spare parts in fiscal years 1994-99. In
addition, the Marine Corps regulation containing policies and procedures for
pricing spare parts is outdated.

Defense Financial Management Regulation 7000.14-R requires the military
services to compute two different prices for reparable spare parts each
fiscal year. One of these prices is called a standard price. Regulations
stipulate that the standard price consist of the most current procurement
price paid plus a surcharge. The second price is the exchange price. This is
used when customers turn in a reparable item. Regulations provide that the
exchange price be computed by either adding a surcharge to a part's repair
costs or taking a percentage of a part's standard price. The regulations
require that an exchange price be set for groupings of similar parts.

The Marine Corps revises standard prices each fiscal year by using one of
two approaches. If a part has been procured recently, the Marine Corps
applies a surcharge rate to the procurement price to establish a standard
price for the following fiscal year. If a part has not been procured
recently, the Marine Corps applies a price change rate to the standard price
to establish a new standard price for the next fiscal year. The Marine
Corps' use of the price change rate to compute standard prices has caused
prices to be overstated in some years and understated in others.

In their annual pricing process, the other military services comply with
Defense pricing procedures by removing the current year's surcharge from the
standard price--thus leaving the latest procurement price--and then adding
the next year's surcharge. The Marine Corps' approach, however, is
completely different. The Marine Corps adds the price change rate to a
part's current standard price to compute the next year's standard price.

To illustrate the effect of the Marine Corps' methodology, we used both
approaches to compute prices for a driveshaft assembly the Marine Corps
purchased at a unit price of $279.79 in fiscal year 1996. The Marine Corps'
approach resulted in a fiscal year 1999 standard price that was about 6
percent higher than it would have been had the price been computed in
accordance with regulations (see fig. 4).

Source: our analysis of Marine Corps data.

In addition to standard prices, exchange prices established by the Marine
Corps are higher than they would have been had actual repair costs been used
to compute them. In fiscal year 1997, the Marine Corps began calculating
exchange prices for parts by charging customers 57 percent of the standard
price. Marine Corps officials told us that they developed the factor using
the average repair costs of a random number of parts, but they were unable
to provide documentation showing how they arrived at the 57-percent factor.

We obtained the Marine Corps' recorded repair costs of 65 different parts
refurbished in 1998. Of these 65 parts, 58 (about 89 percent) were in four
federal supply groups.9 We calculated average exchange prices by groups on
the basis of repair costs provided by the Marine Corps. As shown in figure
5, the exchange prices we computed using reported repair costs ranged
between 25 and 35 percent of the standard prices for parts in these groups
and averaged 33 percent of standard prices of all parts. Because the Marine
Corps computes exchange prices at 57 percent of standard prices, the prices
charged to customers were 22 to 32 percentage points higher than they should
have been.

Source: our analysis of Marine Corps data.

After we presented our analysis to Marine Corps officials, they agreed that
the standard 57-percent factor was not the most equitable way to compute
exchange prices.

In some cases, the Marine Corps established incorrect standard prices for
parts because of mathematical mistakes, computer program flaws, or
oversights. These problems included the following:

ï¿½ The price change rate for fiscal year 1999 was 3.61 percent, but the
Marine Corps added 36.1 percent to the prices of its reparable spare parts
to establish fiscal year 1999 prices. The Marine Corps charged its customers
these erroneous prices from October 1 through December 31, 1998. After
recognizing the error, the Marine Corps repriced the parts and refunded
customers about $2.4 million in overcharges. We brought to the Marine Corps'
attention 16 additional parts that had not been repriced at the time of our
review.

ï¿½ The Marine Corps did not compute standard prices using the most recent
procurement prices when it placed the remaining parts in the stock fund in
fiscal year 1998. We noted 20 instances in which the most recent procurement
prices were not used. As a result, 14 parts were underpriced by $330 to
$28,832 and 6 parts were overpriced by $31 to $15,750 in fiscal year 1999.

ï¿½ The Marine Corps calculated standard prices for at least 88 parts placed
in the stock fund in fiscal year 1998 by using a price change rate of 19.17
percent. It should have used the 43.75-percent surcharge rate, as directed
by Marine Corps headquarters. As a result, 86 of these parts were
underpriced by $15 to $83,769 in fiscal year 1999.

ï¿½ The Marine Corps computed some prices in fiscal years 1998-99 on the basis
of outdated procurement prices. As a result, prices for some parts were
incorrect.

ï¿½ The Marine Corps used a 19.17-percent price change rate to calculate
fiscal year 1998 standard prices for parts not recently procured. We
recalculated the price change rate and found that it should have been 17.77
percent.

ï¿½ The Marine Corps was not billing customers for parts purchased from
contractors and shipped directly to customers. This practice is contrary to
Defense Financial Management Regulation 7000.14-R, which requires that
customers be billed for the acquisition cost of a part plus an appropriate
surcharge. The Marine Corps agreed that it had not billed customers for
direct-shipped parts but was unable to provide the dollar value of these
parts.

Marine Corps budget documents showed an accumulated gain of about $48
million at the end of fiscal year 1999 (see fig. 6). The flawed processes
used by the Marine Corps to price parts, coupled with the pricing errors and
oversights previously discussed, contributed to this condition.

Source: our analysis of Marine Corps data.

Defense Financial Management Regulation 7000.14-R states that revolving
funds are expected to operate on a break-even basis over time--that is, not
make a profit or incur a loss but simply recover all costs.

The Marine Corps does not have an up-to-date regulation for pricing
reparable spare parts that are managed by the stock fund. The latest
regulation containing pricing guidance is in Marine Corps Order 4443.8F,
dated July 6, 1989, before the Marine Corps placed reparable spare parts in
the stock fund and began charging customers for them. The Marine Corps did
issue a logistics bulletin in April 1994 that discussed stock fund pricing
matters, but the bulletin was not a regulation. The Marine Corps has no
written guidance setting out current policies and procedures concerning such
matters as how standard and exchange prices are to be developed.

After reviewing our findings, officials from the Office of the Assistant
Secretary of Navy (Financial Management and Comptroller) and the Marine
Corps agreed to update the Marine Corps pricing regulation. They also agreed
to review and correct the prices of all reparable spare parts managed by the
Marine Corps. In addition, they agreed to

ï¿½ discontinue using the price change rate to compute standard prices for
parts not recently procured and to use the approach prescribed by Defense
regulations;

ï¿½ discontinue use of the standard 57-percent factor to compute exchange
prices and use repair costs plus a surcharge or, when repair costs are not
available, a percentage of parts' standard prices calculated by groupings of
similar parts;

ï¿½ establish procedures to prevent the future occurrence of the pricing
errors we found; and

ï¿½ make an assessment to determine whether the Marine Corps should reduce its
surcharge, resulting in lower prices and in turn bringing the accumulated
gain closer to zero.

Actions being taken by the Marine Corps should correct the pricing problems
we found. If properly implemented, these corrective actions should improve
significantly the accuracy of Marine Corps spare part prices, reduce the
amount of accumulated gains on the sales of parts, and provide procedures
for use by Marine Corps personnel in managing stock fund operations. These
actions should be implemented so that prices established for fiscal year
2001 are correct.

We recommend that the Secretary of Defense direct the Commandant of the
Marine Corps to prepare an action plan with target dates for completing
corrective actions so that changes are incorporated in fiscal year 2001
prices.

In written comments on a draft of this report, the Department of Defense
generally agreed with our recommendation and principal findings. However,
the Department objected to our use of the term "profit" when discussing the
accumulated gains10 from supply operations, saying it believed the term
"profit" was misleading. In support of that point, the Department provided a
cash flow analysis from fiscal year 1995 through 1999 that shows cash
collections exceeded disbursements by $68.5 million during that time period.
In addition, the Department stated that from fiscal year 1992 through 1994,
disbursements exceeded collections by $103.8 million, leaving a net loss of
$35.3 million over the entire period of fiscal year 1992 through 1999.
Accordingly, the Department requested the word profit be removed from our
report.

We do not agree that the cash flow analysis (showing collections and
disbursements) presented by the Department is a more appropriate measure of
the accumulated operations of the Marine Corps supply management system than
accumulated gains or losses. Federal accounting standards require agencies
to prepare reports on the results of operations on an accrual rather than
cash basis because an accrual basis provides a better matching of an
entity's use of resources with the period of concern. Cumulative
accrual-based information (shown as accumulated gains or losses) will be
considerably different that cumulative cash-based data if, as happens in the
stock fund, the Marine Corps pays for repair of an item and holds the item
in inventory for several years before selling it to its customers. On a cash
basis, disbursements for repairs will be recorded when payment for the
repair is made, usually in the year repaired. On an accrual basis, repair
expenses will be recognized and revenue recorded in the year the item is
sold. In accordance with Defense regulations, the Marine Corps has reported
the operating position of the fund on an accrual basis. In February 2000,
the Marine Corps reported an accumulated gain of $48 million and that result
is presented in this report. However, to minimize confusion, we have used
the term "accumulated gain" rather than "profit" to describe the position of
the fund.

The Department also provided technical comments, which we incorporated where
appropriate. The Department of Defense's comments appear in appendix V.

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

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

David E. Cooper
Defense Acquisitions Issues

Scope and Methodology

To determine changes in the prices of Marine Corps reparable spare parts, we
first reviewed the historical pricing of the 890 parts initially placed in
the stock fund to identify those that remained in the fund during the 5-year
period of fiscal years 1994-99. For the 703 parts we identified as remaining
in the stock fund throughout the 5-year period, we used simple averages to
compute both the annual price changes and the average price change in fiscal
years 1995-99. We averaged the percentage changes in the standard prices to
compute the price change for each year. We were unable to compute price
trends for the entire 5-year period because neither the Marine Corps nor the
Defense Logistics Information Services11 could provide fiscal year 1994
standard prices. We also identified those parts sold between October 1,
1996, and April 25, 1999. We computed the average price change for these
parts and analyzed these changes in detail.

To establish an inflation index for these price trends, we used the producer
price index commodity group Intermediate Materials, Supplies, and Components
minus Foods and Feeds. This tracks partly processed commodities that require
further processing to reach the finished goods stage. To eliminate such
items as processed fuels, we used the subgroup Materials and Components for
Manufacturing. This includes items such as motor vehicle parts, electronic
components and accessories, motors, and generators. We judged the items in
this subgroup to be the most similar to those managed by the Marine Corps.
We did not use the consumer price index because it focuses on consumer goods
and does not contain items similar to Marine Corps reparable spare parts.

To evaluate the processes the Marine Corps uses to price spare parts, we
examined the practices it uses to compute standard and exchange prices. We
also examined Defense Financial Management Regulation 7000.14-R, which
contains pricing guidance and establishes the benchmark against which stock
fund performance is to be measured. Specifically, it sets the accumulated
operating result, i.e., accumulated gain or loss, as the standard for
breaking even. We used those figures, provided in the President's Budget, to
determine whether the Marine Corps was complying with Defense policy. We
also reviewed procurement prices paid, surcharges added, and repair costs of
parts. We compared the Marine Corps' processes with those the other services
use to establish standard and exchange prices. We also examined the Marine
Corps' calculations of surcharges and the price change rates and their
application to procurement and standard prices. In addition to determining
whether the Marine Corps was setting prices as it intended, we examined the
prices the Marine Corps actually charged its customers.

While we did not validate or verify computer-generated data, we obtained
information from Marine Corps officials showing how the data was generated
and used in the annual pricing processes to establish prices. We compared
computer-generated data with information from other sources, when available,
and made Marine Corps officials aware of instances in which data was
questionable or wrong. In those instances, we attempted to determine whether
the errors were caused by what the Marine Corps actually did by comparing
the questionable data with information obtained from other sources such as
the Defense Logistic Information Services. We also provided details of
questionable transactions to Marine Corps officials and requested that they
review the information to determine its accuracy.

We performed our work at Marine Corps Headquarters and at the Marine Corps
Logistics Base, Albany, Georgia; the Office of Assistant Secretary of Navy
(Financial Management and Comptroller); and the Office of Under Secretary of
Defense (Comptroller) and discussed various aspects of the pricing of Marine
Corps reparable spare parts with officials there. We performed our work
between February 1999 and May 2000 in accordance with generally accepted
government auditing standards.

Marine Corps Surcharge and Price Change Rates

This appendix discusses changes in the Marine Corps' surcharge and price
change rates in fiscal years 1997-2000. We did not include information on
fiscal year 1996 rates because problems with Marine Corps supply management
systems caused some of the data for this year to be wrong. We included
information on the fiscal year 2000 rates because the data was available.

For parts that have been procured recently, the Marine Corps adds a
surcharge to the acquisition costs to establish standard prices. For parts
that have not been procured recently, the Marine Corps adds a change
rate--the customer price change rate--to the existing standard prices to
establish standard prices for the next fiscal year. The price change rate is
computed by using the surcharge rates.

To compute the surcharge rate, the Marine Corps estimates the costs of its
supply management operations and projects the amount of anticipated sales in
the next fiscal year. The Marine Corps divides the estimated costs by the
projected sales to arrive at the surcharge rate. Changes in either estimated
costs or projected sales would cause the surcharge rate to change from year
to year. Table 1 shows the elements the Marine Corps used to compute
surcharge rates in fiscal years 1997-2000. 12

 (dollars in millions)
                              Fiscal year
 Element
                              1997    1998    1999   2000
 Estimated cost of operations
 Supply operationsa           $4.0    $4.3    $3.5   $4.4
 Distribution depotsb         1.3     1.6     2.4    5.2
 Depot washoutc               1.0     1.0     1.0    1.3
 Obsolescence/lossesd         0.2     0.2     0.2    0.2
 Transportatione              0.1     0.2     0.1    0.1
 Prior year gains/lossesf     (2.2)   -       (0.9)  0.3
 Cash recoveryg                       1.6     0.5    -
 System sustainmenth          -       -       2.0    1.4
 Totals                       $4.4    $8.9    $8.8   $12.9

 Projected sales              $17.9   $20.3   $19.2  $35.10

 Surcharge rate (percent)     24.59i  43.75i  45.83  36.75

aManaging reparable spare parts (includes estimated costs for labor,
utilities, and base support).
bOperating storage depots.
cReplacing parts that can no longer be repaired.
dReplacing parts that were lost or became obsolete.
eTransportation for part shipments.
fAdjustments for prior years' gains or losses in supply operations.
gCosts added to recover cash for Navy stock fund losses.
hCosts of operating automated information systems.
iWill not compute due to rounding.

Source: Marine Corps.

The fluctuation in surcharge rates responded, in large part, to changes in
certain cost elements. For example, in some years, part of the prior year
gain was applied to reduce the costs of operations--in fiscal year 1997 this
element reduced costs by one-third. In other years, no reduction took place.
Other charges affecting the cost of operations, and therefore surcharge
rates, included a charge to recover cash for Navy stock fund losses and a
charge for operating the automated information system.

In fiscal years 1997-98, the surcharge rate increased from 24.59 percent to
43.75 percent. Table 2 shows the estimated costs and projected sales the
Marine Corps used to compute the surcharge rates for these fiscal years.

 (dollars in millions)
                              Fiscal year
 Element
                              1997    1998    Difference
 Estimated cost of operations
 Supply operations            $4.0    $4.3    $0.3
 Distribution depots          1.3     1.6     0.3
 Depot washout                1.0     1.0     0.0
 Obsolescence/losses          0.2     0.2     0.0
 Transportation               0.1     0.2     0.1
 Prior year gains/losses      (2.2)           2.2
 Cash recovery                        1.6     1.6
 System sustainment
 Totals                       $4.4    $8.9    $4.5
 Projected sales              $17.9   $20.3   $2.4
 Surcharge rates (percent)    24.59a  43.75a  19.16

aWill not compute due to rounding.

Source: our analysis of Marine Corps data.

In fiscal year 1998, estimated costs more than doubled (from $4.4 million to
$8.9 million) while projected sales rose only 13.4 percentage points. Two
elements accounted for most of the increase in estimated costs. First, in
fiscal year 1997, the Marine Corps lowered estimated costs by $2.2 million
to return to customers gains from prior years' supply management operations
(shown in table 2 as prior year gains/losses). In 1998, the Marine Corps
made no adjustment for this item. Second, the Marine Corps contributed $1.6
million to the Navy stock fund in fiscal year 1998 because of the fund's
financial difficulties (shown in table 2 as cash recovery).13 There was no
charge for this item in fiscal year 1997.

In fiscal years 1998-99, the surcharge rate experienced a more modest
change, increasing from 43.75 percent to 45.83 percent. Table 3 shows the
estimated costs and projected sales the Marine Corps used to compute the
surcharge rates.

 (dollars in millions)
                              Fiscal year
 Element
                              1998    1999   Difference
 Estimated cost of operations
 Supply operations            $4.3    $3.5   $(0.8)
 Distribution depots          1.6     2.4    0.8
 Depot washout                1.0     1.0    0.0
 Obsolescence/losses          0.2     0.2    0.0
 Transportation               0.2     0.1    (0.1)
 Prior year gains/losses              (0.9)  (0.9)
 Cash recovery                1.6     0.5    (1.1)
 System sustainment                   2.0    2.0
 Totals                       $8.9    $8.8   $(0.1)
 Projected sales              $20.3   $19.2  $(1.1)
 Surcharge rates (percent)    43.75a  45.83  2.08

aWill not compute due to rounding.

Source: our analysis of Marine Corps data.

Despite the small change in the surcharge rate, there were large changes in
the estimated costs of several elements:

ï¿½ A $2-million charge was added to maintain automated information systems
previously managed by the Defense Logistics System Center (shown in table 3
as system sustainment).

ï¿½ The charge for operating distribution depots increased by $800,000 because
the Defense Logistics Agency increased its charges.

ï¿½ A $500,000 charge for cash recovery was added to contribute to the
solvency of the Navy stock fund.

ï¿½ Costs were decreased by $900,000 for prior year gains to return those
gains to customers.

In fiscal years 1999-2000, the surcharge rate dropped from 45.83 percent to
36.75 percent. Table 4 shows the estimated costs and projected sales the
Marine Corps used to compute the surcharge rates for these fiscal years.

 (dollars in millions)
                              Fiscal year
 Element
                              1999    2000   Difference
 Estimated cost of operations
 Supply operations            $3.5    $4.4   $0.9
 Distribution depots          2.4     5.2    2.8
 Depot washout                1.0     1.3    0.3
 Obsolescence/losses          0.2     0.2    0.0
 Transportation               0.1     0.1    0.0
 Prior year gains/losses      (0.9)   0.3    1.2
 Cash recovery                0.5            (0.5)
 System sustainment           2.0     1.4    (0.6)
 Totals                       $8.8    $12.9  $4.1
 Projected sales              $19.2   $35.1  $15.9
 Surcharge rates (percent)    45.83a  36.75  9.08

aWill not compute due to rounding.

Source: our analysis of Marine Corps data.

The surcharge rate dropped primarily because of a sharp increase in
projected sales. This increase came about because the Marine Corps began
charging customers for more than 2,000 additional parts it added to the
stock fund in 1998. Before fiscal year 2000, customers were not charged for
these parts, and the costs to manage them were funded through direct
appropriations.

There were changes in cost elements as well:

ï¿½ Costs for supply operations, distribution depots, and depot washout rose
by $4.0 million primarily to support the increased number of parts managed
by the fund.

ï¿½ $300,000 was added for prior year gains/losses to recover from customers
prior years' fund losses, whereas $900,000 was returned to customers in
fiscal year 1999 for prior years' gains.

ï¿½ Costs for system sustainment decreased.

ï¿½ There was no cash recovery assessment for the Navy's portion of the stock
fund.

Defense Financial Management Regulation 7000.14-R requires that a customer
price change rate be computed each fiscal year. Office of the Secretary of
Defense and Navy officials told us that the price change rate should be used
to make adjustments to the amount of appropriated funds requested by
customers to purchase spare parts. If the price change is a negative
percentage, the customer's budget request is reduced. If the price change is
a positive percentage, the customer's budget request is increased. Although
the Marine Corps is using the price change rate to compute standard prices,
this rate was never intended to be used for this purpose. Table 5 shows the
rates the Marine Corps computed for fiscal years 1997-2000.

 (percent)
 Fiscal year
 1997      1998    1999  2000
 (10.69)   19.17a  3.61  (5.14)

aThe rate should have been 17.77 percent in fiscal year 1998, as explained
in the report.

Source: Marine Corps.

The price change rate is derived from the same elements (estimated costs and
projected sales) used to compute surcharge rates and is essentially the
percentage difference between the current and prior fiscal year surcharge
rates (adjusted for inflation). If there are large changes in surcharge
rates between fiscal years, there will be large changes in the price change
rates.

Average Percentage Changes in Standard Prices, Fiscal Years 1995-99 and
1997-99

                                                   Total price change
                                                   percentage
 Federal supply groupa
                                       Number of
                                       parts       1995-99     1997-99
 10 − Weapons                    17          76.5        19.0
 12 − Fire control equipment     21          7.1         31.9
 23 − Ground effect vehicles,
 motor vehicles, trailers, and cycles  4           57.3        33.2
 25 − Vehicular equipment
 components                            45          12.9        30.9
 28 − Engines, turbines, and
 components                            23          11.3        20.9
 29 − Engine accessories         4           71.3        23.5
 39 − Materials handling
 equipment                             2           0.2         23.5
 43 − Pumps and compressors      4           0.2         23.5
 48 − Valves                     1           72.2        23.5
 49 − Maintenance and repair
 shop equipment                        11          46.0        77.5
 58 − Communication, detection,
 and coherent radiation equipment      128         13.7        31.2
 59 − Electrical and electronic
 equipment components                  316         9.5         23.1
 60 − Fiber optics materials,
 components, assemblies, and           2           0.2         23.5
 accessories
 61 − Electric wire, and power
 and distribution equipment            52          8.4         29.9
 66 − Instruments and laboratory
 equipment                             38          4.6         24.1
 70 − Automatic data processing
 equipment, software, supplies, and    26          17.4        28.4
 support equipment
 81 − Containers, packaging, and
 packing supplies                      9           41.5        23.5
 Totals/averages                       703         13.6b       26.8

aThe federal supply classification system is used to classify supply items
identified under the federal cataloging program. A federal supply group is
used to group similar items (including spare parts) into broad commodity
categories for management purposes.

bThe average annual price increase for these parts was 3.4 percent.

Marine Corps Sales, by Federal Supply Group, From October 1, 1996, Through
April 25, 1999, and Average Percentage Price Increases in Fiscal Years
1997-99

                                                               Average
                        Number                   Percentage of percentage
 Federal supply group   of      Sales value      total sales   price
                        parts                    value         increase
                                                               1997-99
 10 − Weapons     13      $1,932,867.00    5.1           17.6
 12 − Fire
 control equipment      12      2,999,853.00     7.9           38.2
 23 − Ground
 effect vehicles, motor
 vehicles, trailers,    1       196,304.00       0.5           23.5
 and cycles
 25 − Vehicular
 equipment components   31      3,429,578.00     9.0           34.3
 28 − Engines,
 turbines, and          13      4,224,967.00     11.1          13.0
 components
 29 − Engine
 accessories            2       836,926.00       2.2           23.5
 43 − Pumps and
 compressors            2       175,058.00       0.5           23.5
 49 − Maintenance
 and repair shop        4       82,310.00        0.2           172.2
 equipment
 58 −
 Communication,
 detection, and         77      18,817,272.00    49.6          35.2
 coherent radiation
 equipment
 59 − Electrical
 and electronic         123     3,757,243.00     9.9           22.7
 equipment components
 60 − Fiber
 optics materials,
 components,            1       2,432.00         0.0           23.5
 assemblies, and
 accessories
 61 − Electric
 wire, and power and    14      870,637.00       2.3           39.5
 distribution equipment
 66 − Instruments
 and laboratory         7       248,509.00       0.7           22.7
 equipment
 70 − Automatic
 data processing
 equipment, software,   8       56,985.00        0.2           23.0
 supplies, and support
 equipment
 81 − Containers,
 packaging, and packing 5       319,359.00       0.8           23.5
 supplies
 Totals/averages        313     $37,950,299.00a  100.0         29.6

aTotal does not add because of rounding.

Comments From the Department of Defense

GAO Contacts and Staff Acknowledgments

David E. Cooper (202) 512-4841

Karen S. Zuckerstein (202) 512-6785

In addition to those named above, George C. Burdette, Maria Storts, Michele
Mackin, Robert DeRoy, Catherine Baltzell, Charles Perdue, and Gregory
Pugnetti made key contributions to this report.

(707388)

Table 1: Marine Corps Surcharge and Price Change Rates 7

Table 2: Elements Used to Compute Marine Corps Surcharge Rates, Fiscal Years
1997-00 23

Table 3: Estimated Costs and Projected Sales, Fiscal Years 1997-98 24

Table 4: Estimated Costs and Projected Sales, Fiscal Years 1998-99 25

Table 5: Estimated Costs and Projected Sales, Fiscal Years 1999-2000 26

Table 6: Customer Change Rates, Fiscal Years 1997-00 27

Figure 1: Marine Corps Logistics Base, Albany, Georgia 6

Figure 2: Changes in Marine Corps Prices Compared with Changes in Prices of
Similar Items in the Private Sector 8

Figure 3: Effect of Annual Price Adjustments on the Price of a Communication
Terminal 9

Figure 4: Example of Setting Part Prices 12

Figure 5: Reported Repair Costs as a Percentage of Standard Prices 13

Figure 6: Accumulated Gains by Fiscal Year 15
  

1. Reparable spare parts are parts that can be economically repaired,
whereas consumable parts are expendable items such as paint, fuel, and
supplies.

2. These 703 parts were the only ones the Marine Corps managed over the
entire period.

3. The Marine Corps has two depots--one at Barstow, California, the other at
Albany, Georgia. The Defense Logistics Agency operates these depots and
distributes spare parts for all types of Marine Corps ground combat and
support equipment.

4. Recently procured parts are those that have been purchased during a
specific 12-month period. The 12-month procurement window for fiscal year
1999, for example, was July 1, 1997, through June 30, 1998.

5. The Marine Corps computes the price change rate by calculating the
percentage difference between the current and prior fiscal year surcharge
rates (adjusted for inflation).

6. There is no inflation index that directly relates to Marine Corps spare
parts. To approximate inflation for these parts, we used the producer price
index, which is a family of indexes that measures average changes in the
selling prices received by domestic producers of goods and services. We
selected the index for the commodity group Intermediate Materials and
Components for Manufacturing less Foods and Feed. We used the subgroup
Materials and Components for Manufacturing, which includes items such as
motor vehicle parts, electronic components and accessories, motors, and
generators. These items are similar to the Marine Corps spare parts we
examined.

7. We excluded 14 parts from our analysis because the Marine Corps did not
change the price of the parts in at least one year, made a mathematical
error in pricing the part, or did not have a procurement history for the
part.

8. It should be noted that our financial statement audits have highlighted
the Department's continuing problems in capturing and accurately reporting
full costs. See Department of Defense: Progress in Financial Management
Reform (GAO/T-AIMD/NSIAD-00-163 , May 9, 2000), p. 31.

9. The federal supply classification system is used to classify supply items
identified under the federal cataloging program. A federal supply group is
used to group similar items (including spare parts) into broad commodity
categories for management purposes.

10. The Department use the term "accumulated operating result."

11. The Defense Logistics Information Services, part of the Defense
Logistics Agency, maintains logistics data, including standard prices for
all the military services.

12. We did not validate the estimated costs or projected sales the Marine
Corps used to compute the rates. However, we reported in May 1999 that the
Department of Defense had long-standing problems accumulating and reporting
the full costs associated with working capital fund operations. These
problems have resulted in large fluctuations in surcharge rates and,
therefore, in the prices charged to customers. See Status of Financial
Management Weaknesses and Actions Needed to Correct Continuing Challenges,
(GAO/T-AIMD/NSIAD-99-171, May 4, 1999).

13. This was the first time since spare parts were initially placed in the
stock fund in fiscal year 1994 that the Department of Defense directed the
Marine Corps to contribute cash to the Navy's portion of the stock fund.
*** End of document. ***