Contract Management: DOD's Use of Recovery Auditing (Letter Report,
06/05/2000, GAO/NSIAD-00-134).

Pursuant to a congressional request, GAO provided information on the
Department of Defense's (DOD) use of recovery auditing, a process that
identifies and collects overpayments made to vendors, focusing on DOD's:
(1) progress in recovering overpayments and the reasons for any delays;
and (2) use of recovery auditing.

GAO noted that: (1) since the program began in 1996, the Defense Supply
Center has collected $5.3 million of the $17.9 million in overpayments
it now recognizes as valid; (2) the Supply Center has written letters to
vendors demanding payments of an additional $4.0 million and continues
to negotiate with other vendors to settle disputed payments; (3) the
collection process has proceeded slowly in part because of the time and
effort required to review disputed claims; (4) in particular, the Supply
Center and vendors disagree over the interpretation of contract
provisions that require vendors who sell brand-name products to
guarantee that prices offered to the government are as good as those
offered to their most favored customers; (5) 34 of the 59 vendors who
have received letters demanding payment have appealed to the Armed
Services Board of Contract Appeals; (6) DOD is expanding its use of
recovery auditing; and (7) since June 1999, six Defense agencies have
contracted for recovery audit services, and a seventh is planning to do
so soon.

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

 REPORTNUM:  NSIAD-00-134
     TITLE:  Contract Management: DOD's Use of Recovery Auditing
      DATE:  06/05/2000
   SUBJECT:  Department of Defense contractors
	     Overpayments
	     Defense audits
	     Contractor payments
	     Contract oversight
	     Internal controls

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GAO/NSIAD-00-134

National Security and
International Affairs Division

B-284763

June 5, 2000

The Honorable Thomas Harkin
United States Senate

The Honorable Peter DeFazio
The Honorable George Miller
The Honorable Carolyn Maloney
House of Representatives

You requested that we evaluate the Department of Defense's (DOD) use of
recovery auditing, a process that identifies and collects overpayments made
to vendors. This report assesses DOD's progress in (1) recovering
overpayments and the reasons for any delays and (2) expanding the use of
recovery auditing. It responds to your request and updates information we
reported in 1998 and 1999.1

Although the vast majority of payment transactions are processed correctly,
errors occur. Vendors may make pricing errors on their invoices, forget to
apply advertised discounts, neglect to offer allowances and rebates,
miscalculate freight charges, and so forth. These mistakes, when not caught,
result in overpayments. In 1996, the Defense Supply Center, Philadelphia,
hired a private firm to identify overpayments on its purchases of food and
grocery items, clothing and textiles, and medicines and medical supplies.
This effort was a demonstration program exploring the applicability of
recovery auditing to DOD purchases. The recovery auditor, Profit Recovery
Group International, identified and documented overpayments. The Supply
Center reviewed identified overpayments, accepted those it viewed as valid
and supported, and initiated collection efforts. If the DOD contracting
officer could not resolve the claim through negotiation, the officer issued
a letter of final decision demanding payment of the claim. Vendors have the
right to appeal the contracting officer's final decision to the Armed
Services Board of Contract Appeals or to a federal court.

Since the program began in 1996, the Defense Supply Center has collected
$5.3 million of the $17.9 million in overpayments it now recognizes as
valid. The Supply Center has written letters to vendors demanding payments
of an additional $4.0 million and continues to negotiate with other vendors
to settle disputed payments. The collection process has proceeded slowly in
part because of the time and effort required to review disputed claims. In
particular, the Supply Center and vendors disagree over the interpretation
of contract provisions that require vendors who sell brand-name products to
guarantee that prices offered to the government are as good as those offered
to their most favored customers. Thirty-four of the 59 vendors who have
received letters demanding payment have appealed to the Armed Services Board
of Contract Appeals.

DOD is expanding its use of recovery auditing. Since June 1999, six Defense
agencies have contracted for recovery audit services, and a seventh is
planning to do so soon.

To minimize disagreements between DOD and vendors in the future, we are
recommending that, after the Armed Services Board of Contract Appeals rules
on the appeals, DOD examine the need to clarify price warranty provisions in
its contracts. DOD concurred with our recommendation.

In September 1996, the Defense Supply Center, Philadelphia, awarded a
contract to Profit Recovery Group International for recovery auditing
services. This demonstration program responded to a congressional mandate
(section 354 of the Fiscal Year 1996 National Defense Authorization Act) to
evaluate the feasibility of using private firms to identify overpayments to
vendors. Under the program, the recovery auditor was tasked with identifying
potential overpayments. The Supply Center would then assess whether proposed
claims were valid and adequately supported and would begin collection
efforts for those it recognized as valid. Collection efforts continue,
although the demonstration program ended in November 1999.

To collect an overpayment, a contracting officer can notify a vendor by
issuing a letter of apparent indebtedness. If the claim is not resolved
through negotiations, federal regulations require the contracting officer to
issue a letter of final decision demanding payment. The vendor can send the
government payment for the amount owed or, more typically, the government
can offset the claim against future invoices submitted by the vendor. A
vendor can appeal the contracting officer's final decision to the Armed
Services Board of Contract Appeals or a federal court.

The contracts identified by the recovery auditor involving possible
overpayments included purchases of subsistence (food and grocery) items,
clothing and textiles, and medicines and medical supplies made during fiscal
years 1993-95. The food and grocery items were purchased by the Supply
Center for resale to the Defense Commissary Agency and shipped to
commissaries in Europe. Many of these purchases involved brand-name
products, such as Kellogg's Corn Flakes, and a specific brand was specified
for procurement, precluding full and open competition.2

In 1998, the House report (H.R. Rep. 105-532) accompanying the fiscal year
1999 DOD authorization bill directed DOD to expand its use of recovery
auditing to at least two commercial functions within its working capital
funds accounts3 and to issue a competitive request for proposals by December
31, 1998. In March 1999, we reported that DOD had not expanded the program
as directed because it was still reviewing the merits of recovery auditing.

By the time the demonstration program ended in November 1999, the recovery
auditor had identified $30.4 million in potential overpayments, and the
Supply Center had recognized $22.9 million as valid and supported. On March
1, 2000, however, the Supply Center reduced that figure to
$17.9 million because it concluded it did not have sufficient data to
support $5.0 million in overpricing claims. (Additional data on overpayment
claims is in app. I.)

From 1996, when the program began, until March 2000, the Supply Center
recovered $5.3 million in overpayments and wrote letters of final decision
demanding payment of $4.0 million. Thirty-four vendors have appealed to

the Armed Services Board of Contract Appeals. In response to the appeals,
the Supply Center has suspended collection efforts on these claims.4

The collection process to recover overpayments has proceeded slowly because,
according to the Supply Center, it takes a long time to review vendors'
positions on these claims. The Supply Center's efforts to collect
overpayments included sending letters of apparent indebtedness to vendors,
rather than letters demanding payment, to afford vendors the time to provide
documentation refuting overpayment claims. The Supply Center also hosted
legal reviews and numerous meetings, both within government and with
vendors, to review overpayment claims and the methodology by which the
claims were determined. In addition, Supply Center officials stated that
they tried to negotiate settlements to preclude appeals to the Armed
Services Board of Contract Appeals or federal court. Although some
recoveries were realized, vendors generally did not agree with the claims.
Consequently, the Supply Center issued letters of final decision demanding
payment. Because of the appeals, the Supply Center does not plan to pursue
additional claims on the basis of the same issues until the Armed Services
Board of Contract Appeals issues a ruling. However, the Supply Center
continues to attempt to negotiate with vendors to resolve other claims and
reach settlement.

Price Warranty Provisions and Overpricing Claims

A majority of overpayments claims are based on a contract clause that
requires vendors of brand-name subsistence items to warrant that all prices
offered the government be as low as those offered to their most favored
customer.5 This price warranty provision is included in contracts for
brand-name products, such as Kellogg's Corn Flakes because specifying a
brand precludes full and open competition.

This provision expressly includes quantity discounts, allowances, rebates,
special promotions, and billing advantage. The Supply Center maintains that
the contractual obligation to offer the government the same billing
advantage as is offered to a brand-name vendor's most favored customer
includes cash discounts for prompt payment. For example, many vendors offer
commercial customers 2-percent discounts if the bill is paid within
10 days rather than 30 days.

To ensure compliance with the price warranty, contracts for brand-name
products give the government's contracting officer the right to examine the
vendor's books, documents, records, and any other evidence necessary to
determine the basis for the prices offered. The price warranty provision
states that the government's examination ". . .will compare the average
price paid by the government versus commercial customers for the same item
during the offeror's latest fiscal year." As a result of the price warranty
provisions, the recovery auditor identified overpayments for:

ï¿½ cash discounts offered to commercial customers that had not been offered
to the Supply Center and

ï¿½ overpricing (the Supply Center paid a higher price than commercial
customers).

However, when letters of apparent indebtedness were initially sent and, more
recently, when letters of final decision demanding payment were sent to
vendors of brand-name items, vendors protested. Many disagreed with the
Supply Center's cash discount claims. Some argued that (1) they had already
deducted the discount from the price in their invoice; (2) other benefits
the government received, such as vendor stocking and in-store
demonstrations, compensated for not offering cash discounts; and (3) cash
discounts were not offered because, historically, the government did not pay
its bills within the discount period.

In contrast, the Supply Center contends that a cash discount is not a
component of a product's unit cost but rather recognition of the time-value
of money and is designed to induce accelerated payment of invoices. Hence,
regardless of the price of an item, if cash discounts were offered to
commercial customers for prompt payment, they should have been offered to
the Supply Center. In response, vendors argue that the basis of an
overpayment claim, as specified by contract, is the average price paid by
the government versus commercial customers for the same item during the
offeror's latest fiscal year. As a result, they dispute the Supply Center's
claim that a cash discount is separate and distinct from the average price
paid by the government.

Vendors also contest overpricing claims. Vendors argue that the government
received most favored customer prices because of price reductions given
directly to European commissaries. Vendors maintain that they gave price
reductions directly to the European commissaries for promotional purposes
and that these reductions reduced costs to most favored customer prices.6

Vendors also argue that the methodology used to establish overpricing claims
is flawed because, for example, the claims were based on what the government
paid, rather than the prices offered to the government. According to
vendors, due to consumer demand patterns, the government does not accept all
promotional offers. For example, because commissary customers may choose to
buy relatively large quantities of 40-ounce containers of catsup compared
with 14-ounce containers, commissaries will likely accept all of a vendor's
promotional dollars for catsup in the
40-ounce size. This translates into a price reduction for the larger
container of catsup but not for the smaller. Hence, the commissary rejected
promotional offers, and thus price reductions, on the 14-ounce containers.
Vendors contend that overpricing claims did not reflect price reductions
rejected by the government but accepted by a commercial customer. They say
that the price warranty provision covers prices offered, not prices
received. Finally, vendors argue that higher prices are driven by the
additional costs of doing business with the government, including (1) the
requirement to distribute and deliver products to commissaries, (2) the
regulation for extra stenciling, labeling, and marking on cases, and (3) the
need for personnel familiar with military buying practices in both customer
service and accounts receivable.

Generally, the Supply Center and its recovery auditor could not verify that
price reductions received after the payment transaction reduced costs to
most favored customer prices because supporting documentation was not
available or not easily retrieved. For example, although the recovery
auditor reviewed documentation maintained at both the Defense Finance and
Accounting Service (the payment center) and the Supply Center, neither of
these organizations had been apprised of or had received any documentation
relating to the deals and allowances made after the Supply Center resold
brand-name products to European commissaries. Claims for overpayment were
made on the basis of documentation made available to the recovery auditor.
Also, the recovery auditor did not have documentation on promotional price
reductions that had been accepted by commercial customers but not by the
government. Records of deals and allowances resulting in price reductions
are located at the commissaries in Europe or with vendors.

The Supply Center attempted to obtain the pricing information and financial
data needed to substantiate the vendors' arguments, first by requesting the
data from the Defense Commissary Agency and then directly from the vendors.
The Commissary Agency responded that it did not have the resources to
provide the required documentation and did not provide the requested data.
The vendors did not provide the documentation either. Vendors responded that
the price warranty provision gives the government the right to examine their
books, documents, records, and any other evidence necessary to determine the
basis of prices offered. However, they argue that the government has only
the right of access and that they are not required to conduct a review of
their own records and select documentation for the government's review.
Further, some vendors said it would take a large number of hours and a
substantial financial cost to retrieve the requested data, if it were still
available, from fiscal years
1993-95.

In the end, the Supply Center pursued overpayment claims on the basis of
cash discounts and began issuing letters of final decision demanding
payment. The Supply Center believes that in order for vendors to contest
these claims successfully, they must present documentation that supports
their position. However, the Supply Center chose not to pursue the
$5 million in overpayment claims that were based on overpricing because it
did not have sufficient documentation to verify whether price reductions
were given directly to European commissaries, reducing prices to those of
most favored customers.

The House report (H.R. Rep. 105-532) accompanying the fiscal year 1999 DOD
authorization bill directed DOD to expand the recovery audit demonstration
to at least two commercial functions within its working capital fund
agencies. The report directed DOD to issue a competitive request for
proposals by December 31, 1998.

DOD did not expand the program by December 1998 because it was still
reviewing the merits of recovery auditing. However, in response to an August
1998 DOD memorandum encouraging the use of recovery auditing, the Defense
Logistics Agency has contracted competitively for audit recovery services at
all four of its buying centers. In addition, the
U.S. Transportation Command and a Navy working capital fund have also
contracted for recovery audit services. Finally, a working capital fund
agency within the U.S. Army Tank-Automotive and Armament Command plans to
contract for recovery audit services by June 30, 2000. The working capital
fund agencies that have contracted or soon plan to contract for recovery
audit services are shown in table 1.

 Working capital fund agency                          Date of recovery
                                                      audit contract
 U.S. Transportation Command                          June 9, 1999
 Defense Supply Center−Philadelphia             September 1, 1999
 Defense Supply Center−Columbus                 September 1, 1999
 Defense Supply Center−Richmond                 September 1, 1999
 Defense Energy Supply Center                         September 1, 1999
 Navy Working Capital Fund−Supply Management,
 Naval Inventory Control Point, Wholesale Commercial  February 22, 2000
 Accounts
 U.S. Army Tank−Automotive and Armament         Plans to contract by
 Command, Integrated Materiel Management Center       June 30, 2000

The Air Force has expressed an interest in recovery auditing and is
evaluating whether to use it, as have the other recipients of the August
1998 DOD memorandum, the Defense Commissary Agency, Defense Information
Services Agency, and Defense Finance and Accounting Service.

The recovery audit process identified overpayments to vendors of grocery,
medical, and clothing items. Collections of these claims have been slow, in
large part due to disagreements between vendors and the Supply Center. These
disagreements center on the meaning of contract provisions covering the
pricing of brand-name items. These issues are currently before the Armed
Services Board of Contract Appeals.

To minimize disagreements between DOD and vendors in the future, we
recommend that, after the Armed Services Board of Contract Appeals rules on
the appeals, the Secretary of Defense examine the need to clarify price
warranty provisions in its contracts.

In written comments on a draft of this report, DOD concurred with our
recommendation. DOD stated that recovery auditing is a tool of good
government and is useful for identifying overpayments and underpayments and
providing feedback for continuous process improvement. It also stated that
since some claims are under litigation, our report should only discuss
arguments that have been made to the Armed Services Board of Contract
Appeals. DOD also offered technical comments, which we incorporated as
appropriate. DOD comments are reprinted in appendix II.

All of the arguments presented in the report were expressed to us by either
vendor or government officials. We have not limited our presentation to
arguments made to the Board and DOD offered no rationale for such a
limitation. Rather, we included these issues to illustrate that price
warranty clauses have been subject to varying interpretations.

To determine the progress DOD has achieved in recovering
contractor-identified overpayments since our first report, we reviewed the
types and amounts of overpayments the Supply Center considered as valid and
supported. We then reviewed the efforts the Supply Center made to notify
vendors of the overpayments and to recover them. We also obtained the views
on the validity of the overpayment claims from the vendor community through
the correspondence they sent to the Supply Center and by interviewing
officials from their trade association, the American Logistics Association,
and two vendors, General Mills and Kraft Foods, Inc.

To determine the progress DOD has achieved in expanding its use of recovery
auditing, we obtained information from the recipients of an August 1998 DOD
memorandum encouraging the use of recovering auditing.

We performed our work at the Defense Finance and Accounting Service−
Columbus, Columbus, Ohio; the Defense Supply Center−Philadelphia,
Philadelphia, Pennsylvania; the Defense Commissary Agency, Fort Lee,
Virginia; the American Logistics Association, Washington, D.C.; General
Mills, Minneapolis, Minnesota; and Kraft Foods Inc., Northfield, Illinois.

We performed our review from October 1999 through March 2000 in accordance
with generally accepted government auditing standards.

Unless you publicly announce its contents earlier, we plan no further
distribution of this report until 30 days from its issue date. At that time,
we will send copies to interested congressional committees; the Honorable
William Cohen, Secretary of Defense; the Honorable F. Whitten Peters,
Secretary of the Air Force; the Honorable Louis Caldera, Secretary of the
Army; the Honorable Richard Danzig, Secretary of the Navy; Lieutenant
General Henry T. Glisson, Director of the Defense Logistics Agency; the
Honorable Jacob Lew, Director of the Office of Management and Budget; and
other interested parties. We will make copies available to others upon
request.

Please contact me at (202) 512-4587 if you or your staff have any questions
concerning this report. Key contributors to this report were Karen S.
Zuckerstein and Daniel J. Hauser.
David E. Cooper
Associate Director
Defense Acquisitions Issues

Overpayment Claims

 Commodity                      Number of vendors  Identified   Recovered
 Subsistence                    219                $12,517,455  $2,043,220
 Medicines and medical supplies 27                 2,849,595    2,060,251
 Clothing and textiles          48                 2,519,826    1,240,806
 Total                          294                $17,886,876  $5,344,277

Source: Profit Recovery Group International.

 Type                                               Identified  Recovered
 Cash discounts

 Not offered (discount not offered to the Supply
 Center but offered to commercial customers)
                                                    $12,033,919 $1,709,855

 Earned but not taken (the payment system did not
 override cash discount terms specified in contract
 with more liberal terms specified on invoice)
                                                    609,373     306,656
 Deducted at wrong rate                             104,237     98,858
 Subtotal                                           $12,747,529 $2,115,369

 Overcharge by comparison (vendor charged the
 Supply Center more than its most favored customer)
                                                    1,851,865   925,943
 Duplicate payment                                  597,153     437,549

 Unposted credit memorandum (as a result of
 returned merchandise, vendor sent a credit
 memorandum that remained outstanding)
                                                    1,429,998   1,267,435
 Accounting error                                   440,985     450,102a
 Price protection (losses to the value of a
 retailer's inventory, should a vendor reduce
 prices to other retailers)                         519,128     124,329

 Allowances (vendor failed to give financial
 considerations in exchange for meeting specific
 requirements such as advertising or promotional
 sales)
                                                    33,797      0

 Shortage discrepancy (vendor sent less than the
 quantity ordered)
                                                    421         421
 All other errors                                   266,000     23,130
 Total                                              $17,886,876 $5,344,278

a One vendor, in responding to an overpayment claim, identified and repaid
an additional $9,117 in overpayments.

Source: Profit Recovery Group International.

Comments From the Department of Defense

(707440)
  

1. Contract Management: Recovery Auditing Offers Potential to Identify
Overpayments (GAO/NSIAD-99-12 , Dec. 3, 1998) and Contract Management: DOD
Is Examining Opportunities to Further Use Recovery Auditing (GAO/NSIAD-99-78
, Mar. 17, 1999).

2. In its comments, DOD pointed out that brand-name products were a small
subset of food items purchased by the Supply Center.

3. Working capital fund agencies bill customers, primarily the military
services, for the cost of their operations. A working capital fund is a
revolving fund that generally relies on sales revenues, rather than direct
appropriations, to finance its operations.

4. In its comments, DOD pointed out that the Supply Center suspended
collection action against vendors who requested a deferment until the
Defense Logistics Agency (the headquarters agency for the Supply Center)
completes its evaluation of the request.

5. This provision was in contracts for subsistence items bought by the
Supply Center for resale to the Defense Commissary Agency. Because the
Supply Center no longer purchases these items for the Defense Commissary
Agency, it no longer includes this provision in its contracts. However, the
Commissary Agency uses similar language in its contracts.

6. Price reductions are given through vendor credit memoranda and these
credit memoranda result in the vendor writing a check directly to the
commissary.
*** End of document. ***