Defense Supply: Inventories Contain Nonessential and Excessive Insurance
Stocks (Letter Report, 01/20/95, GAO/NSIAD-95-1).

The Department of Defense (DOD) is stocking hundreds of millions of
dollars of what are known as insurance items---mission-essential spare
parts and supplies, such as aircraft doors, rudders, and ejection seats,
that are not expected to fail during normal use--that are not mission
essential and in quantities that violate DOD regulations. The
unnecessary inventories occurred because inventory officials do not
periodically review insurance items to ensure that they are
mission-essential and stocked in appropriate quantities. It costs DOD
millions of dollars each year to manage and maintain its unnecessary
inventories.

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

 REPORTNUM:  NSIAD-95-1
     TITLE:  Defense Supply: Inventories Contain Nonessential and 
             Excessive Insurance Stocks
      DATE:  01/20/95
   SUBJECT:  Military inventories
             Federal supply systems
             Military cost control
             Equipment inventories
             Spare parts
             Inventory control systems
             Logistics
             Surplus federal property
             Aircraft components
IDENTIFIER:  AV-8B Aircraft
             F/A-18 Aircraft
             A-7 Aircraft
             E-2C Aircraft
             
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Cover
================================================================ COVER


Report to the Secretary of Defense

January 1995

DEFENSE SUPPLY - INVENTORIES
CONTAIN NONESSENTIAL AND EXCESSIVE
INSURANCE STOCKS

GAO/NSIAD-95-1

DOD Insurance Stocks


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

  ASO - Aviation Supply Office
  DLA - Defense Logistics Agency
  DISC - Defense Industrial Supply Center
  DOD - Department of Defense

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


B-258425

January 20, 1995

The Honorable William J.  Perry
The Secretary of Defense

Dear Mr.  Secretary: 

The Department of Defense (DOD) stocks hundreds of millions of
dollars of what it calls insurance items to ensure that the
operational capability of a weapon system is not compromised.  These
items are mission essential spare parts and supplies that are not
expected to fail through normal usage.  They include aircraft parts
such as doors, rudders, and ejection seats.  DOD regulations state
that only one replacement unit of an item may be stocked for
insurance purposes. 

We reviewed the Navy's and the Defense Logistics Agency's (DLA)
management of insurance items.  Our objectives were to determine if
insurance stocks were limited to (1) mission essential parts and (2)
one replacement unit as required by DOD regulations. 


   BACKGROUND
------------------------------------------------------------ Letter :1

DOD inventory control points are responsible for managing insurance
items.  We performed our review at the Aviation Supply Office (ASO),
one of two Navy inventory control points, and the Defense Industrial
Supply Center (DISC), one of six DLA inventory control points.  As of
March 1994, ASO managed insurance inventories valued at $193 million
and, as of April 1994, DISC managed insurance inventories valued at
$3 million. 

Spare parts and other supplies normally are designated as insurance
items during the initial provisioning process.  Initial provisioning
is designed to provide parts until there is a requisitioning history
from which relatively accurate forecasts of future demands can be
made.  Typically, these parts support a weapon system during the
first 2 years of operation.  At ASO, contractors or manufacturers
recommend which parts should be stocked for insurance purposes, ASO
reviews these recommendations, and the Naval Air Systems Command
approves the recommendations if it agrees with the contractor and
ASO.  DISC classifies items on the basis of submissions by the using
military service during the initial provisioning process. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :2

ASO and DISC stock millions of dollars of unnecessary insurance
items.  Most are not mission essential and frequently are stocked in
quantities greater than one unit.  ASO records show that only about
10 percent of the insurance items are mission essential.  We
questioned the managers of a sample of these items, and they stated
that about 22 percent are mission essential.  Similarly, DISC records
indicate that only about 42 percent of their insurance items are
mission essential.  We also questioned DISC managers, but none had
responded to the questionnaire at the time our fieldwork was
completed.  Furthermore, contrary to DOD regulations, both ASO and
DISC stock about one half of the insurance items in quantities
greater than one unit. 

The unnecessary inventories occurred because ASO and DISC do not
periodically review insurance items to ensure that they are mission
essential and stocked in appropriate quantities.  It costs DOD
millions of dollars each year to manage and maintain these
unnecessary inventories. 


   MOST INSURANCE ITEMS ARE NOT
   MISSION ESSENTIAL
------------------------------------------------------------ Letter :3

We analyzed ASO and DISC records to identify insurance items and
determine if they were properly classified.  We found that most of
the items were not mission essential and, therefore, should not have
been classified as insurance items.  Table 1 summarizes the results
of our analysis. 



                                     Table 1
                     
                      Analysis of Insurance Items on ASO and
                                   DISC Records


Item
classificati
on              Number   Percent          Cost    Number   Percent          Cost
------------  --------  --------  ------------  --------  --------  ------------
Fully            1,042      10.5   $65,917,000     1,410      42.3    $1,694,000
 justified
 as
 insurance
 item
Not mission      8,118      81.7   109,466,000       325       9.7       222,000
 essential,
 should not
 be
 insurance
 item
Insurance          777       7.8    17,749,000     1,600      48.0       841,000
 item
 justificati
 on was not
 determined
================================================================================
Total            9,937     100.0  $193,132,000     3,335     100.0    $2,757,000
--------------------------------------------------------------------------------
Because only a small percentage of the insurance items were fully
justified in the inventory control point records, we asked item
managers to verify the classification of the insurance items.  We
randomly sampled 329 ASO items and 110 DISC items and sent
questionnaires to item managers asking them to validate the records. 
According to the ASO item managers surveyed, 51 percent of the items
were not mission essential.  Table 2 summarizes the sample results. 



                           Table 2
           
           Summary of Sample Results From ASO Item
                           Managers

Item classification                    Number        Percent
------------------------------  -------------  -------------
Fully justified as insurance               73             22
 item
Not mission essential, should             169             51
 not be insurance item
Insurance item justification               42             13
 could not be determined
Questions not answered                     45             14
============================================================
Total                                     329            100
------------------------------------------------------------
We did not make a similar analysis for DISC because none of the item
managers had responded to the questionnaire at the time our fieldwork
was completed. 


   ESSENTIALITY IS NOT VALIDATED
------------------------------------------------------------ Letter :4

Significant numbers of nonessential parts and supplies continue to be
stocked as insurance items because ASO and DISC do not have the
internal controls to periodically review insurance items to identify
those that are unneeded because they do not meet essentiality
criteria.  As noted in tables 1 and 2, only 10.5 percent of ASO's
insurance items were mission essential according to ASO records and
only 22 percent were mission essential according to item manager
responses to our questionnaire.  At DISC, 42.3 percent were mission
essential according to its records. 

ASO assigns mission essentiality codes on the basis of reports from
end users on how the failure of a part affects mission capability. 
These codes range from one where item failure results in minor
mission impact to one where item failure results in loss of a primary
mission capability.  DISC assigns essentiality codes, called weapon
system indicator codes, on the basis of data provided by the using
military service. 

Neither ASO nor DISC systematically reviews insurance items to
validate the essentiality codes.  ASO does require an annual review
to ensure that the data elements used to prevent automatic purchases
of insurance items are correctly loaded in the computer.  However,
this review does not verify that insurance items are mission
essential.  DISC does not require a review of insurance item
essentiality. 

The absence of essentiality reviews contributed significantly to the
low percentage of mission essential items identified in our review. 
In addition to the 22 percent ASO item managers said were mission
essential, they indicated that 51 percent of the insurance items were
not mission essential and that they either could not or did not
determine essentiality for the remaining 27 percent.  The following
examples illustrate the error conditions identified. 

ASO stocks three skin assembly units used on the AV-8B aircraft as
insurance items.  These units, which are valued at a total of
$158,927, have a nonessential coding in ASO's records.  In responding
to our questionnaire, the item manager agreed with the coding in the
record and indicated that the units were not mission essential. 
These assemblies have been in the Navy supply system since the weapon
system was provisioned in 1986. 

In another case, ASO stocks 12 manual control levers used on the
F/A-18 aircraft as insurance items.  These levers, which are valued
at a total of $997,020, have been in the supply system since 1983. 
Again, the item manager indicated that the lever, although
categorized as an insurance item in the records, was not mission
essential. 


   EXCESSIVE QUANTITIES ARE
   STOCKED
------------------------------------------------------------ Letter :5

Although DOD Material Management Regulation 4140.1-R, dated January
1993, states that only one replacement unit of an item may be stocked
for insurance purposes, we found that ASO and DISC stocked many of
the insurance items in quantities greater than one unit.  This
condition was true for both mission essential items and nonessential
items.  At ASO, 4,997 insurance items, valued at $126 million, or 50
percent, of the
9,937 insurance items were stocked in quantities greater than one
unit.  Of the 1,042 mission essential items included in these totals,
510 items had excessive quantities valued at $49 million.  At DISC,
1,602, or 48 percent, of the 3,335 insurance items were stocked in
quantities greater than one unit, including 784 of 1,410 mission
essential items. 

The reasons for the excessive quantities are similar to the reasons
that nonessential items are stocked as insurance items.  That is,
much of the excessive buildup occurred during the initial
provisioning process.  DOD downsizing and weapon system obsolescence
and retirement also contributed to the stock buildup.  However,
neither ASO nor DISC has established the internal controls to
periodically review insurance items to ensure that quantities are
kept at the allowable stock level of one unit. 

An additional factor contributing to the excessive quantities is the
inventory control points' stock retention policies.  ASO and DISC
have computer programs to identify and recommend excess stock for
disposal.  ASO programs search for stocks in excess of retention
levels and are run for all stocked items, not just insurance items. 
However, irrespective of retention levels, the programs will not
recommend disposal action on quantities that fall below a floor of
five units at ASO.  The DISC programs identify disposal prospects on
a selective basis and have not been run for insurance items. 

The computer programs have not been effective in reducing excess
insurance stocks at ASO for two major reasons.  First, contrary to
DOD regulations, ASO has established retention levels for many
insurance items that exceed the allowed stockage quantity of one
unit.  Second, the requirement that any disposal recommendation leave
an on-hand quantity of five units precludes reducing the stockage
level to one unit.  As a result, only 330 of the 4,997 insurance
items that we found to be overstocked were identified as such by
ASO's computer program. 

The following examples illustrate the overstockage conditions
identified.  ASO stocks 20 aircraft seat structures used on the A-7
aircraft as insurance items.  These structures, which are valued at a
total of $2,559,586, have been in the supply system since 1979.  In
responding to our questionnaire, the item manager indicated that 14
of these units were removed from aircraft as a result of design
changes and were unserviceable.  The remaining six units were
serviceable but exceeded the allowed insurance stock level of one
unit. 

In another case, ASO stocks two electrical equipment racks used on
the E-2C aircraft as insurance items.  These racks, which are valued
at a total of $687,480, exceed the allowed insurance stock level of
one unit but will not be reviewed for potential disposal because the
quantity falls below ASO's on-hand stockage floor of five units.  The
item manager agreed that the racks were in an excess position but
would not recommend this item for disposal because of the on-hand
stockage floor. 


   HOLDING COSTS ARE HIGH
------------------------------------------------------------ Letter :6

In addition to unneeded procurement costs, DOD incurs large costs to
manage and maintain excess inventories, particularly items with low
demand or years of supply on hand.  DOD expresses these holding costs
as a percentage of the value of on-hand inventory.  Holding costs
include investment cost, or the cost of having funds tied up in
inventory; storage costs; and obsolescence costs.  The holding cost
rate varies by inventory control point and averages 22 percent at ASO
and 18 percent at DISC. 

In commenting on our draft report, DOD stated that the holding cost
rates we used may be correct before a purchase decision is made, but
once material is in inventory the risk of obsolescence is represented
as a sunk cost and the opportunity to spend the funds on an
alternative investment has been foregone.  DOD also stated that the
holding cost rates that should have been applied for material in
stock is at least an order of magnitude less than the rates used in
the report. 

DOD did not give an alternative percentage or amount and DOD's
accounting systems are not designed to capture actual holding costs. 
In commenting on another report (GAO/NSIAD-94-110, June 29, 1994),
DOD agreed that unnecessarily large inventories increase holding
costs and acknowledged that holding cost rates that only cover
storage costs may not be appropriate.  For example, reducing
inventories by quantities sufficient to close warehouses would result
in savings that exceed storage costs. 

While it is difficult to precisely determine the costs to manage and
maintain nonessential and excessive insurance stocks, our review and
DOD's comments indicate that these costs would be millions of dollars
a year. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :7

We recommend that the Secretary of Defense direct the Secretary of
the Navy and the Director, Defense Logistics Agency, to (1)
periodically review insurance items to ensure that they are mission
essential and stocked in allowable quantities and (2) dispose of
existing nonessential and excess insurance stock. 

We further recommend that the Secretary of the Navy direct the
Commanding Officer, ASO, to set the retention level for insurance
items at one unit and change the disposal computer program so that
the on-hand stockage floor for these items also is one unit. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :8

DOD generally agreed with the thrust of our recommendations but did
not agree with most of our report findings (see app.  I).  We have
evaluated DOD's comments and continue to believe that our basic
position is sound; that is, the insurance inventories contain
nonessential and excessive stocks.  Our comments on some of DOD's
specific statements are at the end of appendix I. 

With regard to our recommendations, DOD stated that it would issue a
memorandum by June 30, 1995, (1) reemphasizing the need to review
insurance requirements prior to stock replenishment and (2) directing
the disposal of nonessential stocks.  DOD also stated that the Navy
will direct ASO to reduce insurance stocks where the stockage is not
in compliance with DOD regulations. 

The promised actions will be helpful, but they do not go far enough. 
Because insurance items are not expected to fail, most will not be
reviewed if DOD only reviews those in need of stock replenishment. 
We believe that DOD should review all insurance items periodically to
identify nonessential and excessive stocks.  Over one half of the ASO
insurance items have been in the supply system more than 10 years,
and 87 percent have been in the supply system more than 5 years. 
Since then, requirements may have changed due to DOD downsizing and
weapon system modification, obsolescence, or retirement.  Unneeded
insurance stocks tie up warehouse space and increase managerial
burdens. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :9

To determine the adequacy of internal controls in the management of
insurance items, we reviewed DOD, Navy, and DLA procedures;
interviewed agency officials; and analyzed ASO and DISC computer
files that contained insurance item data as of March and April 1994. 
ASO files included the master data file and disposal file.  DISC
files included the combined file (similar to a master data file) and
contract file. 

By reviewing the files, we identified all insurance items managed by
ASO and DISC.  We then analyzed these items to determine which were
classified as mission essential and which were stocked in quantities
greater than one unit.  We did not assess the reliability of these
files.  However, to validate insurance item data, we randomly sampled
items that were not essential or exceeded authorized stock levels. 
The sample included 329 items from ASO files and 110 items from DISC
files. 

We sent a questionnaire to the ASO and DISC item managers responsible
for the sampled items.  We asked the managers to validate and update
the file information, provide opinions on the essentiality of the
items and causes of excess stock buildups, and define the extent that
excess stock was disposable.  Using this data from the ASO managers,
we projected the results to the universe from which the sample items
were drawn at a 95-percent confidence interval.  None of the DISC
item managers had responded to the questionnaire at the time our
fieldwork was completed. 

We performed our review between February and September 1994 in
accordance with generally accepted government auditing standards. 


---------------------------------------------------------- Letter :9.1

The head of a federal agency is required by 31 U.S.C.  720 to submit
a written statement on actions taken on our recommendations to the
Senate Committee on Governmental Affairs and the House Committee on
Government Reform and Oversight not later than 60 days after the date
of the report.  A written statement also must be sent to the Senate
and House 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 appropriate congressional
committees; the Director, Office of Management and Budget; the
Secretary of the Navy; and the Director, Defense Logistics Agency. 

Please contact me at (202) 512-5140 if you have any questions.  The
major contributors to this report are listed in appendix II. 

Sincerely yours,

Mark E.  Gebicke
Director, Military Operations
 and Capabilities Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================== Letter 

See comments 1 to 4. 

See comment 5. 

See comment 6. 



(See figure in printed edition.)



(See figure in printed edition.)

Now on p.  1. 

Now on p.  2. 



(See figure in printed edition.)

Now on pp.  2-3. 

See comment 1. 



(See figure in printed edition.)

See comment 2. 

See comment 3. 



(See figure in printed edition.)

Now on pp.  3-4. 



(See figure in printed edition.)



(See figure in printed edition.)

Now on pp.  4-5. 

See comment 4. 

Now on pp.  5-6. 

See comment 5. 



(See figure in printed edition.)

Now on p.  6. 

Now on p.  6. 



(See figure in printed edition.)

Now on p.  6. 


The following are GAO's comments on the Department of Defense's (DOD)
letter dated November 28, 1994. 


   GAO COMMENTS
----------------------------------------------------------- Letter :10

1. The item mission essentiality codes we used in our analysis are
assigned to items to indicate their level of impact on the mission of
applicable equipment in the event stocks are depleted.  The military
essentiality codes DOD said we should have used are assigned to
indicate the military importance of a part in relation to a higher
component, equipment, or weapon.  Both sets of codes should provide
the same indication of mission essentiality and be based on input
from technical personnel.  We analyzed the item mission essentiality
codes because the Aviation Supply Office's (ASO) records showed these
codes for 92 percent of the insurance items.  We could not analyze
the military essentiality codes because these codes were not shown on
the records ASO provided us for over 99 percent of the insurance
items.  After receiving our draft report, DOD asked the Navy to
determine the distribution of military essentiality codes.  This
analysis showed that 58 percent of the ASO insurance items were
assigned a mission essential code, less than 1 percent were assigned
a not mission essential code, and the remaining 41 percent were blank
and not assigned a code.  The Navy agreed that insurance items that
are not coded as mission essential must be validated. 

2. Although engineers may make essentiality determinations, we opted
to send the questionnaire to the managers that have overall
responsibility for the items.  In making this decision, we consulted
with ASO officials and asked them to review the questionnaire.  We
made their suggested changes and pretested the questionnaire with
item managers before it was finalized.  At no time in the process did
ASO officials indicate that the questionnaire should be sent to
engineers rather than item managers.  Furthermore, we did not ask the
item managers to refrain from consulting with engineers, equipment
specialists, end users, or others with greater technical knowledge in
preparing the responses.  In fact, the responses indicated that such
consultations did take place in some cases. 

3. We did receive responses to our questionnaire.  In July 1994 we
asked the Defense Industrial Supply Center (DISC) to complete the
questionnaire for 110 insurance items, but DISC did not respond to
the request by the time our fieldwork was completed.  However, in
October 1994, after receiving our draft report, the Defense Logistics
Agency (DLA) provided responses for 64 of the 110 items managed by
DISC.  The responses indicated that 14 percent of the insurance items
were mission essential, 43 percent were not mission essential, and
the item managers did not know if the items were mission essential
for the remaining 43 percent.  Also, the responses indicated that 57
percent of the insurance items were stocked in quantities that
exceeded the authorized level of one unit. 

4. At least two sections of the cited regulation state that one unit
of an item may be stocked for insurance purposes.  For example, page
3-3 states that essential items with no forecast of failure may be
stocked as insurance items in quantities not to exceed one
replacement unit. 

5. We have modified the report to address DOD's comments on holding
costs. 

6. At the completion of our fieldwork, we furnished ASO and DISC with
written summaries of our findings and potential recommendations.  We
held an exit conference with ASO officials and gave them the
opportunity to comment on the summary.  We gave DISC officials the
same opportunity, but they did not provide any comments.  All of
these actions were taken before the draft report was submitted to DOD
for formal review and comment.  In addition, prior to the ASO exit
conference and the DISC exit conference offer, we had numerous
discussions with ASO and DISC officials during the course of the
review. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II


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

James Murphy, Assistant Director


   PHILADELPHIA REGIONAL OFFICE
-------------------------------------------------------- Appendix II:2

Edward Rotz, Regional Management Representative
David Pasquarello, Evaluator-in-Charge
James Kurtz, Evaluator
Wayne Turowski, Computer Specialist
