Contract Management: A Comparison of DOD and Commercial Airline
Purchasing Practices (Letter Report, 11/29/1999, GAO/NSIAD-00-22).
Pursuant to a congressional request, GAO provided information on the
Department of Defense's (DOD) purchasing and pricing of commercially
available spare parts, focusing on: (1) a comparative analysis between
the purchasing and pricing practices of selected commercial passenger
and freight airline companies and the practices of DOD; and (2) how
airlines and DOD ensure that they are obtaining reasonable prices when
buying commercial items from sole-source suppliers.
GAO noted that: (1) airlines use a variety of practices to obtain spare
parts at reasonable prices; (2) these practices include analyzing
prices, procuring competitively, utilizing catalog prices (commonly
discounted), negotiating long-term agreements, purchasing new surplus or
reconditioned parts, and sometimes asking for justifications of price
increases; (3) when faced with a sole-source supplier demanding a price
that they believe is unreasonable, some airlines will consider
re-engineering the part and establishing a second source; (4) DOD
policies call for using similar practices when buying commercial spare
parts; (5) contracting officers often rely on competition to ensure
reasonable prices--about 42 percent of fiscal year 1998 spending on
commercial spare parts for aircraft was awarded through full and open
competition; (6) DOD frequently receives discounts on catalog prices
from suppliers, including sole-source suppliers; (7) DOD has also begun
to negotiate longer-term agreements that set prices; (8) in sole-source
situations, contracting personnel perform some price analyses, but GAO's
recent review of these analyses indicated they could be very limited in
scope; and (9) less commonly, DOD will purchase surplus parts or
consider re-engineering a part.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: NSIAD-00-22
TITLE: Contract Management: A Comparison of DOD and Commercial
Airline Purchasing Practices
DATE: 11/29/1999
SUBJECT: Defense procurement
Airline industry
Prices and pricing
Spare parts
Aircraft components
Procurement practices
Private sector practices
Commercial products
Sole source procurement
Comparative analysis
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Report to Congressional Requesters
November 1999
CONTRACT MANAGEMENT
A Comparison of DOD and Commercial Airline Purchasing
Practices
*****************
*****************
GAO/NSIAD-00-22
National Security and
International Affairs Division
B-280496
November 29, 1999
The Honorable James Inhofe
Chairman
The Honorable Charles Robb
Ranking Minority Member
Subcommittee on Readiness and Management Support
Committee on Armed Services
United States Senate
The Department of Defense (DOD) is increasing the use of commercially
available products and services. While the current level of commercial
purchasing is relatively small--about 5 percent of the $2.6 billion spent
on aircraft spare parts in fiscal year 1998/Footnote1/--the Department
expects such purchases to increase in the future and believes determining
fair and reasonable prices for commercial sole-source items will be
particularly challenging.
Because of concerns over the pricing of spare parts for DOD aircraft, you
requested that we compare the purchasing and pricing practices of selected
commercial passenger and freight airline companies with those of DOD. We
placed particular emphasis on how airlines and Defense ensure that they
are obtaining reasonable prices when buying commercial items from sole-
source suppliers.
Our analysis of airline practices is based on discussions with officials
from 10 airlines. Our analysis of DOD's buying practices is based on a
case study review of 65 sole-source purchases at 7 Department buying
centers./Footnote2/ The assessment of DOD's buying practices differs from
the assessment of airline practices in that the Defense assessment covers
both procurement policies and their implementation. The airline assessment
covers only procurement policies.
Results in Brief
Airlines use a variety of practices to obtain spare parts at reasonable
prices. These practices include analyzing prices, procuring competitively,
utilizing catalog prices (commonly discounted), negotiating long-term
agreements, purchasing new surplus or reconditioned parts, and sometimes
asking for justifications of price increases. When faced with a sole-
source supplier demanding a price that they believe is unreasonable, some
airlines will consider re-engineering the part and establishing a second
source.
Department of Defense policies call for using similar practices when
buying commercial spare parts. Contracting officers often rely on
competition to ensure reasonable prices: about 42 percent of fiscal year
1998 spending on commercial spare parts for aircraft was awarded through
full and open competition. The Department frequently receives discounts on
catalog prices from suppliers, including sole-source suppliers. It has
also begun to negotiate longer-term agreements that set prices. In sole-
source situations, contracting personnel perform some price analyses, but
our recent review of these analyses indicated they could be very limited
in scope. Less commonly, the Department will purchase surplus parts or
consider re-engineering a part.
Background
In the absence of competition, DOD has traditionally been able to rely on
cost data to ensure that the prices it pays for spare parts are fair and
reasonable. When DOD purchases noncommercial items, contractors may be
required to provide certified cost or pricing data./Footnote3/ In fiscal
year 1998, DOD obtained certified cost and pricing data for two-thirds of
contract dollars awarded (for noncommercial aircraft parts) without full
and open competition./Footnote4/ By statute, suppliers of commercial items
are not required to submit certified cost or pricing data.
Commercial airlines buy spare parts to support aircraft maintenance and
use a variety of methods to service and maintain aircraft. Nearly all the
airlines we contacted said they perform 90 to 100 percent of routine
aircraft maintenance in-house. Most airlines we surveyed buy the bulk of
their spare parts (80-90 percent) to support these operations directly
from suppliers rather than through third parties. Some larger airlines
also do heavy maintenance, overhauls, and major modifications in-house,
buying spare parts for these tasks. Several smaller airlines contract
these services out using contracts that sometimes include spare parts. In
addition, airlines' contracts for service on repairable parts often
include new parts.
A majority of the airlines we contacted also participate in component
lease/service arrangements such as "power-by-the-hour," "cost-per-
landing," and "cost-per-cycle." Under these agreements, major components
such as engines, wheels and brakes, and other components are leased from a
provider that charges by the hours of use or by the number of landings or
cycles. These agreements may include parts as well as service, but the
specific arrangements vary among the airlines. For example, some airlines
contract for a total parts and service package, while others allow the
service provider to supply only the less costly consumable parts. The
latter airlines purchase the more expensive spare parts themselves. Still
other airlines contract for a maintenance service package that may or may
not include parts but do some of the maintenance themselves.
Balancing the need to maintain minimum inventory with the need to avoid
aircraft grounded by the unavailability of spare parts is the key
challenge for spare parts management. Airlines reported using just-in-time
inventory procedures to eliminate excessive inventories and reduce costs.
Under just-in-time inventory management, parts are held by the supplier
and delivered just prior to scheduled maintenance. At the same time, to
minimize the possibility of an emergency aircraft-on-the-ground situation
due to unavailability of parts, some airlines stock a limited number of
critical items in case the supplier cannot rapidly deliver them.
Purchasing Practices of Commercial Airlines
In interviews with 10 airlines,/Footnote5/ we were told that airlines
employ a variety of practices to obtain spare parts at reasonable prices.
These practices include
o price and part analyses,
o competitive procurements,
o relying on catalog prices (commonly discounted to airlines),
o long-term agreements with suppliers, and
o obtaining new surplus or reconditioned parts.
Airline officials said that when they are faced with purchasing parts from
a sole-source supplier at a price they determine to be excessive, in
addition to trying to negotiate long-term agreements or searching for
surplus parts, they may
o request cost and pricing data or justifications and/or
o re-engineer the part and develop a second source.
In some instances, these strategies are not feasible or not effective in
obtaining reasonable prices from sole-source suppliers. Although they
attempt to use the leverage of future business to encourage concessions,
airlines are sometimes forced to pay the price demanded by the sole-source
supplier.
All airlines we talked with said they buy some of their parts from sole-
source suppliers. Their estimates of how frequently they buy from such
suppliers varied from 5 to 75 percent. Those airlines flying older
aircraft tend to rely less on sole-source suppliers.
Several factors influence the purchasing practices employed by airlines.
Airlines that fly newer aircraft tend to be limited to purchases from the
original part manufacturer. They often rely on catalog prices or negotiate
long-term agreements with suppliers. Airlines flying older aircraft have
additional options. They may use manufacturers other than the original
equipment manufacturer or purchase surplus parts from other airlines or
brokers. When parts are available from multiple sources, competitive
procurement is feasible. Airline policies also affect the choice of
procurement practices. Some airlines are reluctant to buy surplus or
reconditioned parts and prefer original equipment manufacturers to ensure
quality; they use other sources only as an exception.
Airlines also said they will pay a premium price for a part if they have
an extremely urgent requirement. When an aircraft-on-the-ground situation
occurs, airlines will pay premiums of 15 to 25 percent to get the part
within hours. This premium does not include the cost of delivery, which
can be substantial. However, an aircraft that remains grounded can lead to
the loss of significant revenues. Airline inventory management practices
aim to minimize or avoid aircraft-on-the-ground situations while
simultaneously minimizing the resources tied up in inventory.
Several airline officials commented that while the greatest price leverage
is available when they purchase aircraft or major components (i.e.,
engines), it is rarely used. These officials said that it was in their
best financial interest to get the lowest possible price for the initial
purchase and that negotiating a reduction in future spare parts prices
usually means increasing the cost of the initial buy. However, some
airline officials commented that they encourage aircraft manufacturers to
provide direct access to suppliers or to dual-source important components
and parts.
Price and Part Analyses
------------------------
Airlines uniformly reported that they analyze price histories of parts
they have bought to assess the reasonableness of a price. Airlines track
price histories and review them when procuring a particular part. They
also compare the offered price against the price of similar parts.
Airlines also said they search various electronic databases to research
offered prices.
Airline officials emphasized that they examine non-price factors such as
delivery time and technical support in assessing the value of a part. The
assessment of reasonableness is thus based on overall value, including
price, quality, quantity, availability, location, delivery time, technical
support, warranty, and (if it is a used part) documentation and
certification of the part's history.
Airlines may also involve their engineering staff in analyzing how much a
part should cost to manufacture. Purchasing staff are generally aware of
trends in material and other costs that affect manufacturing costs. These
analyses may be used to challenge the offered price and negotiate a lower
one.
Competitive Procurement
-----------------------
Some airlines emphasized that they rely on competition to ensure
reasonable prices. These airlines establish thresholds governing when
competition is required. For example, several airlines said they solicit
three offers for all procurements over $10,000.
Catalog Prices
--------------
Virtually all airlines pay catalog prices for some parts, and they usually
receive discounts on the catalog price. Some airline officials stated that
they pay catalog prices for a majority of their spare part purchases.
These airlines tend to fly newer aircraft and rely on original equipment
manufacturers. In contrast, some airlines report buying less than
20 percent of their parts on the basis of catalog prices. These airlines
have other agreements with suppliers or use alternative manufacturers and
new surplus or reconditioned parts. Some parts are only available from a
single source and are catalog-priced.
Several airline officials emphasized that they carefully scrutinize what
is included in the catalog price, which may include shorter delivery times
or more support services than they require. Others said they accept the
catalog price and negotiate for additional services. Some said they
analyze the reasonableness of a catalog price and sometimes challenge it
if they conclude it is out of line.
Airlines, as final users (rather than distributors), commonly receive a
discount off the catalog price. Discounts can vary from 5 to 40 percent,
with deeper discounts resulting from high usage, dollar value of business,
or long-term agreements. Some airlines said they could find lower prices
on low-usage items from distributors, who have a larger business base and
can buy in larger quantities. Airline officials said they pay full catalog
prices on some sole-source items.
Long-term Agreements
--------------------
Many airlines stated they negotiate long-term agreements with their more
frequent suppliers. These agreements vary in length. Some cover a 1- to
2-year period, while others cover 3 to 5 years.
Agreements that are shorter in length (1 to 2 years) usually lock in
prices and delivery schedules. The longer 3- to 5-year agreements tend to
involve an exclusive buying commitment. These longer-term agreements tend
to cover prices, delivery schedules, and support and may also have
provisions for the supplier to hold inventory for the airline. Agreements
can aid airlines in obtaining lower prices based on the quantities
procured or can induce a sole-source supplier to lower prices to obtain
more business.
Airlines differ in their reliance on long-term supplier agreements. One
airline said it tries to put many of its regular suppliers under
agreements and sees the agreements as an effective arrangement for
obtaining reasonable prices from sole-source suppliers. Others have few
such agreements.
Surplus and Reconditioned Parts
-------------------------------
Some airlines said they use new surplus and/or reconditioned spare parts
to control costs. These airlines use such parts as alternatives to high-
cost sole-source items. Airline officials said that surplus and
reconditioned parts are more readily available for older aircraft.
Cost and Pricing Data
---------------------
Few airlines request cost or pricing data, saying that suppliers are
generally unwilling to supply such data. Those that have requested data
reported that suppliers are usually not cooperative in providing it.
According to an airline association official, airlines may be successful
in obtaining some data if there is a reliability or quality issue
prompting the request.
Some airlines stated they do request cost or pricing justifications and
are successful in obtaining them. Suppliers may sometimes provide
information on changes in material or labor costs that can trigger price
increases.
Re-engineering Parts
--------------------
In selected circumstances, airlines will reverse-engineer a part (i.e.,
develop engineering or design specifications) and establish a second
source for it or manufacture the part themselves. Airline officials said
it is expensive to create a new manufacturing source and that long lead
times are required. The price of the part has to be excessively high and
future purchases substantial enough to justify the expense. They said that
most of the time, other strategies are successful in obtaining more
reasonable prices. Even when negotiations are unsuccessful, airline
officials said that the airlines may be better off accepting the offered
price.
DOD Practices
DOD employs many of the same practices used by commercial airlines in
procuring spare parts. Like commercial airlines, DOD has limited leverage
in negotiating with sole-source suppliers.
The Federal Acquisition Regulation (FAR) requires contracting officers to
perform sufficient price analyses to determine whether offered prices are
fair and reasonable, while at the same time granting them wide latitude in
the types of analysis techniques and extent of analysis they carry out.
The FAR defines price analysis as the process of examining and evaluating
a proposed price without evaluating its separate cost elements or profit.
Price analysis techniques include (1) comparing proposed prices in
response to a competitive solicitation; (2) comparing a currently offered
price to previously paid prices if both the validity of the comparison and
the reasonableness of the previous prices can be established; (3) using
parametric methods such as dollars per pound or other measurement units;
(4) comparing offers to competitive published price lists, published
market prices, and discount or rebate arrangements; (5) comparing proposed
prices with independent government cost estimates; and (6) comparing
proposed prices with prices obtained through market research for the same
or similar items. The FAR allows contracting officers to ask contractors
to provide (when needed) sales prices for the same or similar items, an
explanation of their discount policy, or cost data (but not certified cost
and pricing data). Thus, the range of actions called for in the FAR covers
many of the practices employed by airlines, including analyses of price
histories, market research, independent cost analyses, and competitive
procurement.
Because of concerns about excessive price increases, each of the military
services and the Defense Logistics Agency issued additional guidance
between June and August 19 on the pricing of commercial items. The
guidance cautions contracting officers on the need to fully understand the
basis of commercial catalog prices and not assume that prices are fair and
reasonable just because they are in a published commercial catalog. The
guidance also stresses the importance of negotiating prices when buying
commercial items.
In practice, contracting officers tend to rely to a significant degree on
competition to ensure price reasonableness. About 42 percent of fiscal
year 1998 contract dollars spent on commercial spare parts for aircraft
were awarded through full and open competition. In contrast, only 9
percent of contract dollars spent on noncommercial aircraft parts were
awarded through full and open competition.
While the FAR and other guidance allow the use of a variety of other
practices to ensure price reasonableness, contracting officers tend to
rely on a more limited range of practices. In our June 1999 report, we
discussed the extent of price analysis performed by DOD contracting
personnel when procuring commercial sole-source items. We reported that in
33 of the 65 purchases we reviewed, price analysis consisted of comparing
the offered price with an offeror's catalog or price list and/or with the
prices the government previously paid for the same or similar items.
Contracting officers accepted the offered price in 30 of the 33 purchases
and negotiated lower prices in only 3 cases. In the other 32 purchases,
contracting personnel used one or more additional price analysis tools
such as commercial sales information. Contracting officers accepted the
offered price in 19 of the 32 purchases and negotiated lower prices in 13
cases.
We also found that the price analyses performed by contracting personnel
were often too limited to ensure that prices were fair and reasonable. For
example, some contracting personnel believed that when the offered price
was the same as the catalog or list price, it could be considered fair and
reasonable. In several cases, contracting personnel did not use pertinent
historical pricing information (in the contract files) that could have
been used to raise questions about the reasonableness of offered prices.
In one instance, the offered price increased 548 percent from the price paid
9 years earlier, while in another case, the offered price increased
475 percent. We also identified cases in which contracting officers paid
prices that included unneeded services such as rapid delivery. Moreover,
contracting officers generally did not include a clause in the
solicitation requiring offerors to provide, upon request, information
other than certified cost and pricing data, such as sales data or the
basis of the offered price, in support of their offered prices. Defense
Logistics Agency guidance recommends this clause in all solicitations and
contracts for sole-source commercial items.
Of the 65 cases we reviewed, a catalog or list price was available for 48
items. In 10 cases, DOD received no discount, while in the remaining 38
cases, DOD received discounts ranging from 5 percent to 73 percent off the
catalog price. The discounts were based primarily on the quantities
purchased.
DOD activities are also beginning to make use of long-term agreements to
take advantage of the Department's leverage as a large customer. For
example, the Defense Logistics Agency uses long-term agreements known as
corporate contracts for a number of different engine and aircraft spare
parts. These contracts aggregate the requirements of one or more supply
centers with a single supplier of multiple items. The contracts cover not
only pricing but also distribution and delivery services. They may address
specific spare parts or include a manufacturer's entire commercial price
list. By using these contracts, the Defense Logistics Agency expects to
lower its costs, obtain better delivery times, and reduce its customer
support infrastructure.
The Defense Logistics Agency makes limited use of surplus parts. It buys
such parts infrequently and usually for older aircraft.
DOD policy allows the re-engineering of parts when significant savings can
be demonstrated. Officials stated that this is an expensive undertaking
and is rarely used. However, DOD can determine how much a part should
cost. For example, one Navy unit/Footnote6/ provides "should-cost" and
other price analyses for Navy and Defense Logistics Agency contract
officers on request. This unit can also re-engineer simple parts.
Agency Comments
We requested comments from the Department of Defense on
September 30, 1999. On October 26, 1999, we were told by DOD's Office of
Inspector General that DOD concurs with the report and would not be
providing further comments. We also shared the draft report with airline
officials who had participated in our review. These officials commented
that the report accurately captures the set of tools that airlines use to
acquire spare parts.
Scope and Methodology
To identify the spare parts purchasing and pricing practices of commercial
airlines, we contacted 10 commercial air carriers, including the largest
passenger and cargo air carriers. We visited three airlines to observe and
discuss their spare parts buying operations and contacted the others by
telephone. We obtained much of the data through interviews with commercial
airline spare parts buyers, purchasing supervisors, managers, and
directors. The fleet size of the airlines we contacted ranged from 13 to
over 600 aircraft, and sales volumes ranged from approximately $250
million to $25 billion.
In addition, we discussed commercial practices with officials of four
aircraft industry trade associations: the Air Transport Association of
America, the Airline Suppliers Association, the Aerospace Industries
Association, and the National Defense Transportation Association. The
first 2 represent 95 percent of U.S. passenger and cargo air traffic and
over 200 airline suppliers, respectively.
We also reviewed a comparative analysis of commercial buying practices
prepared by Arthur Andersen's Government Services Division to cross-check
the information we obtained. The report, titled World Class Commercial
Buying Practices Review for Defense Contract Management Command, was
published September 17, 1998.
We compared the information obtained from commercial airline companies and
organizations with the results of a review we recently completed involving
case studies of 65 contract actions undertaken at 7 DOD buying centers:
o Air Force Air Logistics Center, San Antonio, Texas;
o Air Force Air Logistics Center, Oklahoma City, Oklahoma;
o U.S. Special Operations Command, Fort Eustis, Virginia;
o Defense Supply Center, Columbus, Ohio;
o Defense Industrial Supply Center, Philadelphia, Pennsylvania;
o Defense Supply Center, Richmond, Virginia; and
o Naval Inventory Control Point, Philadelphia, Pennsylvania.
The first six were selected because they were major purchasers of
commercial sole-source parts for aircraft. The seventh was selected
because it was located at the same address as the Defense Industrial
Supply Center in Philadelphia.
We judgmentally selected for review 65 sole-source commercial purchases of
over $100,000 where the price was negotiated during fiscal years 1997-98.
For each purchase, we reviewed information in the contract file, including
the price analysis and negotiation memorandums, and discussed this
information with contracting personnel.
We are sending copies of this report to the Honorable William Cohen,
Secretary of Defense; the Honorable Jacob Lew, Director, Office of
Management and Budget; and Lieutenant General Henry T. Glisson, Director,
Defense Logistics Agency. Copies will also be made available to others on
request.
If you have any questions regarding this report, please contact me at
(202) 512-4841. Key contact and contributors to this report are listed in
appendix I.
*****************
*****************
David E. Cooper
Associate Director
Defense Acquisition Issues
--------------------------------------
/Footnote1/-^ From the Department's DD 350 procurement database, which
covers contract actions over $25,000. Aircraft parts were defined as
covering the following federal supply classes: 1560 (aircraft structural
components); 16xx (aircraft components and accessories); 2620 (aircraft
pneumatic tires and tubes); and 2915, 2925, 2935, 2945, 2950, and 2995
(aircraft engine accessories).
/Footnote2/-^ See Contract Management: DOD Pricing of Commercial Items
Needs Continued Emphasis (GAO/NSIAD-99-90, June 24, 1999).
/Footnote3/-^ 10 U.S.C. 2306a defines cost or pricing data as all facts
that prudent buyers and sellers would reasonably expect to significantly
affect price negotiations.
/Footnote4/-^ From the DD 350 database, based on dollar value of contracts
awarded.
/Footnote5/-^ Airborne Express, Alaska Airlines, American Airlines, Aloha
Airlines, Delta Air Lines, Federal Express, Hawaiian Airlines, Polar Air
Cargo, United Airlines, and United Parcel Service.
/Footnote6/-^ Price Fighters Department, Fitting Out and Supply Support
Assistance Center, Navy Supply Systems Command.
GAO CONTACT AND STAFF ACKNOWLEDGMENTS
=====================================
GAO Contact
Karen S. Zuckerstein (202) 512-6785
Acknowledgments
In addition to the name above, Dorian Dunbar, Paul Greeley, Paula
Haurilesko, and Thaddeus Rytel made key contributions to this report.
(707365)
*** End of document. ***