Contractor Overhead Costs: Money Saving Reviews Are Not Being Done As
Directed (Letter Report, 08/03/94, GAO/NSIAD-94-205).

Should-cost reviews are a special form of cost analysis used to evaluate
the economy and efficiency of a contractor's overhead operations.  Since
being told in 1992 to conduct more should-cost reviews, the Defense
Department has only done four of them. Furthermore, all four were done
by the Air Force rather than the Defense Contract Management Command,
the organization primarily responsible for conducting the reviews.
Since 1992, the Command has acknowledged the importance of reviews but
has not begun any because of the time involved in developing regulations
and an approach for performing those reviews.  In June 1993, it asked
its customers to identify potential candidates for should-cost reviews;
they listed 17 candidates.  The Command plans to begin one should-cost
review in July 1994 and another one after a contractor completes a
restructuring action.  The Command did not consider the other 15 good
candidates for should-cost reviews because of steps these contractors
have taken to cut overhead costs.

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

 REPORTNUM:  NSIAD-94-205
     TITLE:  Contractor Overhead Costs: Money Saving Reviews Are Not 
             Being Done As Directed
      DATE:  08/03/94
   SUBJECT:  Defense cost control
             Defense procurement
             Department of Defense contractors
             Contract costs
             Overhead costs
             Auditing procedures
             Defense audits
             Procurement regulation
             Contract monitoring
             Cost analysis

             
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Cover
================================================================ COVER


Report to the Secretary of Defense

August 1994

CONTRACTOR OVERHEAD COSTS - MONEY
SAVING REVIEWS ARE NOT BEING DONE
AS DIRECTED

GAO/NSIAD-94-205

Contractor Overhead Costs


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

  AMC - Army Material Command
  DCMC - Defense Contract Management Command
  DOD - Department of Defense

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


B-257582

August 3, 1994

The Honorable William J.  Perry
The Secretary of Defense

Dear Mr.  Secretary: 

In 1991 and 1992, our office and the Department of Defense (DOD)
Inspector General, respectively, reported that overhead should-cost
reviews had saved hundreds of millions of dollars and recommended
that more emphasis be placed on such reviews.  Should-cost reviews
are a special form of cost analysis used to evaluate the economy and
efficiency of a contractor's overhead operations.\1

In March 1992, the Director of Defense Procurement instructed
contract administration activities to carry out more should-cost
reviews.  The purpose of this report is to advise you of the actions
DOD has taken concerning these reviews. 


--------------------
\1 Costs such as facilities and equipment, general office support,
and supervisors' salaries are typically classified as overhead costs,
or indirect costs, because they are not directly assignable to a
specific contract but benefit more than one contract. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Since being instructed in 1992 to conduct more should-cost reviews,
DOD has done only four such reviews.  Furthermore, all four of these
reviews were initiated by the Air Force rather than the Defense
Contract Management Command (DCMC), the organization primarily
responsible for conducting the reviews.  Since 1992, DCMC has
acknowledged the importance of the reviews, but has not initiated any
because, according to officials, of the time involved in developing
regulations and an approach for performing those reviews.  In June
1993, it asked its customers to identify potential candidates for
should-cost reviews; they identified
17 candidates.  DCMC plans to begin one should-cost review in July
1994 and another one after a contractor completes a restructuring
action.  DCMC did not consider the other 15 good candidates for
should-cost reviews because of actions these contractors had taken to
reduce overhead costs. 


   BACKGROUND
------------------------------------------------------------ Letter :2

In December 1984, DOD announced a program to improve its oversight of
contractor overhead costs and to ultimately reduce these costs.  The
program responded to DOD's concern that inadequate management
attention and surveillance of overhead costs may have allowed defense
contractors to charge improper or excessive overhead costs to defense
contracts.  As part of its program, DOD emphasized the need to use
evaluation tools such as overhead should-cost reviews to help control
costs. 

The overhead should-cost review is a specialized form of cost
analysis that differs from DOD's traditional evaluation methods.  In
traditional evaluations, local contract audit and administration
personnel primarily base their evaluation of forecasted overhead
costs on an examination of historical costs and trends.  In contrast,
overhead should-cost reviews do not assume that a contractor's
historical costs reflect efficient and economical operations. 
Instead, they involve evaluating the economy and efficiency of a
contractor's existing workforce, methods, materials, facilities,
operating systems, and management.  They also involve using an
integrated team of DOD contracting, contract administration, pricing,
audit, and engineering representatives.  These representatives
conduct a comprehensive evaluation of overhead costs to identify both
short- and long-range initiatives needed to improve the economy and
efficiency of a contractor's operations. 

Contractor overhead costs historically have comprised a large part of
the total cost of defense contracts.  As defense budgets decline and
contractor business bases become smaller, overhead costs are likely
to constitute an even larger part of future contract costs. 
Furthermore, DOD's move from fixed-price to cost-type contracts for
development efforts will shift more of the overhead cost risk to the
government. 


   OVERHEAD SHOULD-COST REVIEWS
   HAVE SAVED HUNDREDS OF MILLIONS
   OF DOLLARS
------------------------------------------------------------ Letter :3

On July 1, 1990, all of the services' contract administration
organizations were consolidated into the newly created DCMC\2 within
the Defense Logistics Agency.  After the reorganization, DCMC
performed some should-cost reviews but began to use more reviews of
another type\3 to evaluate contractors' proposed overhead costs.  In
view of the significant decrease in the use of overhead should-cost
reviews, we recommended in our 1991 report\4 that the Secretary of
Defense (1) revise the procurement regulations to provide guidance on
the use of these reviews and (2) place more emphasis on measures to
reduce contractor overhead costs, including use of overhead
should-cost reviews. 

Our 1991 report showed that DOD's overhead should-cost reviews had
saved hundreds of millions of dollars.  For example, the services and
the Defense Logistics Agency estimated that five reviews completed in
fiscal year 1985 had saved $1.1 billion, compared with an estimated
cost of $2.4 million to conduct the reviews.  Further, Air Force
contracting officers reduced contractors' proposed overhead costs by
$2.4 billion as a result of four reviews conducted during fiscal
years 1986 and 1987.  According to the Air Force, the reductions were
double those contracting officers had achieved in prior overhead
negotiations using traditional evaluation techniques. 

For our 1991 report, we examined the results of forward-pricing rate
agreement\5 negotiations at selected contractor locations.  At 12
contractor locations where overhead should-cost reviews were
conducted, DOD negotiators reduced contractors' proposed overhead
costs by $3.8 billion, which was over a 10-percent reduction of the
proposed amount, as a result of should-cost reviews.  In February
1992, DOD's Inspector General issued a report\6 that confirmed our
findings. 


--------------------
\2 As a result of the consolidation, DCMC became responsible for
conducting overhead should cost reviews at all contractor locations,
except those under the auspice of the Supervisor of Shipbuilding,
Conversion, and Repair. 

\3 The other reviews, called "in-depth" reviews, also evaluate the
economy and efficiency of a contractor's operations; however, they do
not approach the depth of coverage or resources used in overhead
should-cost reviews. 

\4 Contract Pricing:  Economy and Efficiency Audits Can Help Reduce
Overhead Costs (GAO/NSIAD-92-16, Oct.  30, 1991). 

\5 A forward-pricing rate agreement is a written agreement between a
contractor and DOD to use certain overhead rates in the negotiation
of contracts or contract modifications over a specified period of
time.  These agreements eliminate the need to negotiate separate
overhead rates for each contract or contract modification at
contractors where the volume of negotiated contracting is
significant. 

\6 Forward Pricing Rate Agreements (Report No.  92-055, Feb.  27,
1992). 


   DOD DIRECTS THAT OVERHEAD
   SHOULD-COST REVIEWS BE DONE
------------------------------------------------------------ Letter :4

In response to our report, the Director of Defense Procurement by
memorandum dated March 31, 1992, submitted proposed regulations on
the use of overhead should-cost reviews to the regulatory review
process.\7 In a separate March 31, 1992, memorandum, the Director,
realizing the benefits of the reviews, instructed contract
administration activities to carry out overhead should-cost reviews
at selected contractors. 

On May 28, 1992, DCMC headquarters advised its district offices that
the Office of the Secretary of Defense had drafted regulations on
performing overhead should-cost reviews and had directed the reviews
be done while the regulations were being processed.  The proposed
regulations were published in the Federal Register for review and
comment on April 6, 1994, over 2 years after they were submitted for
review.\8

Since the Director's 1992 memorandum, only four overhead should-cost
reviews have been done.  Furthermore, DCMC initiated none of these
reviews.  The Air Force initiated three of the reviews because it was
concerned about overhead cost growth in the F-22 fighter aircraft
program.  The fourth review was done to facilitate production
planning.  These four reviews are projected to result in estimated
savings ranging from $271 million to $340 million. 

DCMC officials told us that several factors contributed to their
initiating no reviews.  The primary factor cited was that the draft
regulations could not be issued because of the moratorium.  DCMC
officials said they therefore had to plan for such matters as
contractor selection criteria, risk assessment details, and resources
to do the reviews.  They said these planning activities took a
considerable amount of time to accomplish.  While some planning was
no doubt necessary, overhead cost reviews had been successfully
accomplished in prior years without regulatory guidance and the
Director of Defense Procurement had instructed that the reviews be
done while the regulations were being finalized. 


--------------------
\7 Revisions to the Federal Acquisition Regulation are prepared and
issued through coordinated action of the Defense and Civilian
Acquisition Regulatory Councils.  After these Councils agree on a
revision, it is then published in the Federal Register for public
review and comment. 

\8 At the time the proposed revision was prepared, the administration
had directed agencies to refrain from issuing any proposed or new
regulations.  The moratorium remained in effect until January 31,
1993.  After the moratorium expired, a backlog of regulations had to
be processed. 


   PLANS TO ACCOMPLISH OVERHEAD
   SHOULD-COST REVIEWS
------------------------------------------------------------ Letter :5

Subsequent to DOD's March 1992 instruction to accomplish overhead
should-cost reviews, several DCMC customers, including the Army's
Senior Acquisition Executive, advised DCMC headquarters of their
concern about overhead cost growth and means to control and reduce
these costs.  Although DCMC officials have acknowledged the potential
contribution of should-cost reviews, DCMC has been slow in initiating
such reviews.  The following illustrates how limited the progress has
been. 

  In November 1992, the Army's Senior Acquisition Executive
     identified should-cost reviews as one initiative planned to
     monitor the management of contractor overhead costs.  However,
     DCMC did not make the should-cost reviews a part of its ongoing
     overhead assessment program. 

  In April 1993, the Army Material Command (AMC) expressed the need
     to conduct overhead should-cost reviews at selected contractor
     sites.  It called the March 1992 memorandum a "call to arms" to
     conduct the reviews and already knew which contractors would be
     good candidates.  AMC stated it was ready to supply technical,
     cost and pricing, and administrative talent for accomplishing
     the reviews and requested DCMC's active participation, but DCMC
     did not follow up. 

  In May 1993, DCMC headquarters acknowledged it needed to develop a
     DCMC-wide approach for analyzing, evaluating, assessing, and
     negotiating contractor overhead costs.  As part of the
     agencywide approach, DCMC requested that its customers--the
     services and the National Aeronautics and Space
     Administration--identify candidates for should-cost reviews. 
     The customers recommended a total of 17 candidates for fiscal
     year 1994. 

  In January 1994, DCMC asked its district offices to determine which
     of the 17 reviews to perform first.  In June 1994, DCMC
     headquarters determined that reviews should be done at only 2 of
     the 17 candidates.  One of these reviews is scheduled to begin
     in July 1994, and the other is being delayed until the company
     completes its restructuring action.  The other 15 candidates
     were eliminated because they were considered low risk or, in one
     case, the company was not under DCMC's jurisdiction.  In
     assessing risk, DCMC looked at the stability of the contractors'
     business bases; actions taken to reduce overhead costs; whether
     the contractors had formal plans to reduce overhead costs as
     their business bases fell; and other factors.  The major
     customers of these contractors concurred with DCMC's low risk
     assessment. 

  In June 1994, DCMC headquarters directed its district offices to
     conduct a risk assessment of 78 contractors designated as cost
     monitoring sites\9 to determine the future need for should-cost
     reviews. 


--------------------
\9 DCMC selects contractors as cost monitoring sites based on the
expected sales to the government during the next fiscal year, the
government's share of indirect costs for these sales, and other
criteria. 


   RECOMMENDATION
------------------------------------------------------------ Letter :6

Because DCMC has not responded to the March 1992 instruction on
performing overhead should cost reviews, we recommend that the
Secretary of Defense re-emphasize the instruction and establish
appropriate mechanisms for ensuring that it is carried out in a
timely manner. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

We reviewed various records at DCMC, including information showing
the number of overhead should-cost reviews carried out since the
March 31, 1992, memorandum on these reviews.  We also examined DCMC
records showing future plans for overhead should-cost reviews and the
milestones for accomplishing these reviews.  In addition, we visited
officials in the Office of Assistant Secretary of the Navy, Office of
Assistant Secretary of the Air Force, and AMC and discussed various
aspects of overhead should-cost reviews.  We did not obtain written
agency comments on this report.  However, we discussed our draft
report with officials from the Office of the Secretary of Defense,
the services, the Defense Logistics Agency, DCMC, the Defense
Contract Audit Agency, and the Office of the DOD Inspector General
and have included their comments where appropriate.  We conducted our
review from July 1993 to June 1994 in accordance with generally
accepted government auditing standards. 


---------------------------------------------------------- Letter :7.1

As you know, 31 U.S.C.  720 requires the head of a federal agency to
submit a written statement of the actions taken on our
recommendations to the Senate Committee on Governmental Affairs and
the House Committee on Government Operations not later than 60 days
after the date of the report.  A written statement must also be
submitted to the House and Senate Committees on Appropriations with
the agency's first request for appropriations made more than 60 days
after the date of the report. 

We are sending copies of this report to the Director, Defense
Logistics Agency; Commander, DCMC; the Secretaries of the Air Force,
the Army, and the Navy; and interested congressional committees.  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.  Other major contributors to this
report are listed in appendix I. 

Sincerely yours,

David E.  Cooper
Director, Acquisition Policy, Technology,
 and Competitiveness Issues


MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix I


   NATIONAL SECURITY AND
   INTERNATIONAL AFFAIRS DIVISION,
   WASHINGTON, D.C. 
--------------------------------------------------------- Appendix I:1

John K.  Harper


   ATLANTA REGIONAL OFFICE
--------------------------------------------------------- Appendix I:2

George C.  Burdette
Anne-Marie Olson
Amy S.  Parrish