Defense Downsizing: Selected Contractor Business Unit Reactions (Letter
Report, 05/03/95, GAO/NSIAD-95-114).

This report examines how the recent decline in defense spending has
affected individual business units of major defense contractors.  GAO
selected business units from six of the top 10 defense contractors in
1993--General Dynamics, General Motors, Lockheed, Martin Marietta,
McDonnell Douglas, and United Technologies.  These units were engaged
primarily in defense work, an important part of their corporations'
total government sales.  GAO compares defense expenditures over several
years and changes in the business units' (1) sales and employment levels
and (2) spending on independent research and development, bid and
proposal preparation, capital improvements, and facilities.

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

 REPORTNUM:  NSIAD-95-114
     TITLE:  Defense Downsizing: Selected Contractor Business Unit 
             Reactions
      DATE:  05/03/95
   SUBJECT:  Department of Defense contractors
             Defense contracts
             Reductions in force
             Contractor personnel
             Research and development costs
             Defense industry
             Future budget projections
             Defense budgets
             Military downsizing
             Comparative analysis

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


Report to Congressional Requesters

May 1995

DEFENSE DOWNSIZING - SELECTED
CONTRACTOR BUSINESS UNIT REACTIONS

GAO/NSIAD-95-114

Defense Downsizing


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

  B&P - bid and proposal
  DOD - Department of Defense
  IR&D - independent research and development

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


B-258875

May 3, 1995

The Honorable Floyd D.  Spence
Chairman
The Honorable Ronald V.  Dellums
Ranking Minority Member
Committee on National Security
House of Representatives

The Honorable James V.  Hansen
The Honorable Norman Sisisky
House of Representatives

In accordance with a September 26, 1994, request from the former
Chairman and Ranking Minority Member, we examined the impact of the
recent decline in defense expenditures on individual business units
of major defense contractors.  We compared defense expenditures over
a number of years and changes in the business units' (1) sales and
employment levels and (2) their spending on independent research and
development and bid and proposal (IR&D/B&P)\1

preparation, capital improvements, and facilities.  To provide
comparability and perspective, all of the sales and spending levels
in this report are expressed in fiscal year 1995 dollars and measured
from various base years. 

We selected business units from 6 of the top 10 defense contractors
in 1993--General Dynamics, General Motors, Lockheed, Martin Marietta,
McDonnell Douglas, and United Technologies.  The units selected were
primarily engaged in defense work and comprised an important part of
their corporations' total government sales.\2 To protect proprietary
data, we have not disclosed the identities of the business units and
have frequently interchanged the business unit labels (A-F) used
throughout this report.  While the changes at these business units
are not projectable to the entire defense industry, they provide some
insight into the impact of defense downsizing. 


--------------------
\1 IR&D is research and development initiated and conducted by
contractors but is not specified under any contract or grant.  It is
funded and managed at the contractor's discretion from contractor
controlled resources, with a portion of the costs later recovered
through overhead.  B&P is the cost incurred in preparing, submitting,
and supporting bids and proposals (solicited and unsolicited) on
potential government or nongovernment contracts. 

\2 Includes sales made to foreign governments through the U.S. 
government. 


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

The Congress wants a strong defense industrial base and has directed
the Secretary of Defense to report annually on the ability of
industry to support U.S.  national security objectives.  The Congress
directed the Secretary to consider in the analysis for that report
such factors as levels of spending for capital investment and
research and development.  In June 1993, the Department of Defense's
(DOD) Inspector General criticized DOD's first report as being of
limited use in helping congressional leaders make informed judgments
because DOD lacked an adequate information system to carry out the
assessment. 

Defense industry representatives also criticized that report.  One
common criticism was that the majority of the report's data applied
to corporations rather than their defense segments.  The second DOD
report, released in September 1994, also concentrated on the
corporate level rather than individual business units.  Other studies
of the effects of the spending decline have also assessed the impact
at the corporate level rather than the individual business unit. 
Another shortcoming in many of these assessments was that they
measured the severity of the decline in defense expenditures only
from the peak years of the 1980s and not from other years in the
cycle of defense expenditures as well. 


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

Measured from their peak years, the six business units we visited had
experienced sales decreases ranging from 21 percent to 54 percent
through 1993 and estimated declines ranging from 50 percent to 73
percent through the latest year projected.  The resulting employment
reductions ranged from 30 percent to 76 percent through 1993 and
planned reductions ranging from 44 percent to 79 percent through the
latest year projected. 

From their peak year spending levels through 1993, the six units had
reduced IR&D/B&P spending ranging from 31 percent to 71 percent and
projected reductions ranging from 41 percent to 84 percent through
the latest year projected.  The six units had also reduced
expenditures for capital improvements by an average of 80 percent
through 1993 and, through the latest year projected, estimated an
average reduction of 76 percent in these expenditures. 

Although these business units have significantly reduced spending in
these areas, projections by some of the units are still higher than
their (1) 1976 levels--the lowest peacetime defense spending level
since the Korean War buildup--and (2) 1980 levels--the year before
the Reagan administration military buildup. 

The defense industry has adjusted to previous spending reductions. 
The current post-Cold War reduction is only 2 percentage points
greater than the reduction after the Vietnam War and is taking place
over a period that is 2 years longer.  However, unlike other
drawdowns, defense contractors view the current decline as permanent
and have developed a variety of strategies to deal with reduced
defense spending. 


   DEFENSE EXPENDITURES
------------------------------------------------------------ Letter :3

Since the World War II drawdown, defense spending has experienced
three peaks associated with the Korean War, the Vietnam War, and the
Reagan administration military buildup.  In fiscal year 1989, defense
expenditures\3 reached their highest peacetime level since World War
II, exceeding defense spending at the peak of the Korean War and
almost matching spending during the Vietnam War.  Defense
expenditures in fiscal year 1989 were $354.1 billion, but had
declined to $274.5 billion by fiscal year 1994, a reduction of $79.6
billion or 22 percent.  The Clinton administration is projecting
defense expenditures of $224.5 billion in fiscal year 2000, which
represents a $129.6-billion, or a 37-percent, decline in defense
spending since fiscal year 1989.  Figure 1 shows the trend in defense
expenditures after the end of World War II. 

   Figure 1:  Defense Expenditures

   (See figure in printed
   edition.)

Note:  Figures for fiscal years 1995 through 2000 are executive
branch projections. 

Although most defense authorities agree that the post-Cold War
decline in spending is significant, it is comparable to the Vietnam
War drawdown.  As shown in table 1, the current decline is only 2
percentage points greater than the Vietnam War drawdown, which was
spread over an 8-year period, whereas the post-Cold War drawdown is
currently projected over a 10-year period.  However, unlike the
Vietnam War drawdown, defense contractors view the current decline as
permanent, not cyclical. 



                           Table 1
           
                 Cyclical Declines in Defense
           Expenditures (1995 dollars in billions)

                                                 Expenditure
Time period                                      s
-----------------------------------------------  -----------
Vietnam War drawdown

1968                                             $358.0

1976                                             $231.0

Overall reduction                                35 percent

Time span                                        8 years

Post-Cold War drawdown

1989                                             $354.1

1999                                             $223.8

Overall reduction                                37 percent

Time span                                        10 years
------------------------------------------------------------
Measured against other years, the $260.2 billion in defense spending
projected for fiscal year 1995 is about 13 percent greater than the
$231 billion expended during fiscal year 1976 and about 4 percent
greater than the $251.4 billion expended in fiscal year 1980.  Fiscal
year 1976 is a significant benchmark because it represents the lowest
level in peacetime defense spending since the Korean War.  Fiscal
year 1980 is significant because it was the year prior to the
beginning of the Reagan administration defense buildup.  Based on
current projections, peacetime defense spending will remain above the
fiscal year 1976 level until fiscal year 1998, when spending is
projected to decline to $225.1 billion. 


--------------------
\3 Many of the studies that assessed the impact of defense downsizing
used budget authority to measure the impact.  However, we used budget
expenditures because expenditures provide a more accurate assessment
of the impact. 


   DECLINE IN SELECTED BUSINESS
   UNIT SALES
------------------------------------------------------------ Letter :4

According to officials of the six business units we visited, the
decline in defense spending since the late 1980s has significantly
affected their defense sales.  We compared the peak sales by these
business units during the mid-to-late 1980s with their sales in 1993
and the latest year projected.\4 Measured from their peak sales
years, we found that the business units' sales decreases ranged from
21 percent to 54 percent through 1993 and that the units were
estimating decreases ranging from 50 percent to 73 percent through
the latest year projected.  The projected weighted average decline
over the businesses was about 55 percent.  Figure 2 shows the actual
and projected sales decreases by business unit. 

   Figure 2:  Actual and Projected
   Reduction in Sales

   (See figure in printed
   edition.)

Although sales declines from the peak years are significant, several
of the business units had sales that were actually lower in 1976 and
1980 than their future projections.  Table 2 compares the business
units' forecasted sales with their 1976 and 1980 sales.  As shown,
two of the business units projected their future sales to be higher
than their 1976 sales, and three of the business units projected
their future sales to be higher than their 1980 sales. 



                           Table 2
           
           Comparison of Forecasted Sales With 1976
                        and 1980 Sales


                    1976 through last   1980 through last
Business unit       year forecasted     year forecasted
------------------  ------------------  --------------------
A                   74-percent          13-percent increase
                    increase

B                   33-percent          17-percent increase
                    increase

C                   54-percent          16-percent decrease
                    decrease

D                   Not available       62-percent decrease

E                   Not available       29-percent increase

F                   Not available       Not available
------------------------------------------------------------

--------------------
\4 Projected sales are presented for the latest year forecasted by
the business units at the time of our visits.  The latest years
forecasted varied from 1997 to 2001, and peak years varied from 1985
to 1989. 


   CONTRACTORS REDUCE SPENDING IN
   RESPONSE TO SALES DECLINES
------------------------------------------------------------ Letter :5

Defense contractors have taken and are continuing to take aggressive
actions to reduce spending as a result of post-Cold War sales
declines.  The following discussion deals with actions taken in the
areas of employment levels, IR&D/B&P expenditures, capital
improvements, and facilities. 


      CUTBACKS IN EMPLOYEES
---------------------------------------------------------- Letter :5.1

The six business units have made large reductions in the number of
employees since their peak employment years\5 of the mid-to-late
1980s.  Through 1993, the units' workforce reductions ranged from 30
percent to 76 percent.  Through the latest projected year, the units'
estimated reductions ranged between 44 percent to 79 percent.  Three
of the units projected reductions of over 75 percent, while the other
three units projected reductions ranging from 44 percent to 57
percent.  Figure 3 provides an overview of actual and projected
employment reductions by business unit. 

   Figure 3:  Actual and Projected
   Reductions in Total Employment

   (See figure in printed
   edition.)

Unlike sales where several of the business units projected higher
figures in the future than in 1976 and 1980, all of the units for
which data were available projected lower employment levels in the
future than they had in 1976 and 1980.  Table 3 compares projected
employment with the 1976 and 1980 levels. 



                           Table 3
           
           Comparison of Forecasted Employment With
                   1976 and 1980 Employment


                    1976 through last   1980 through last
Business unit       year forecasted     year forecasted
------------------  ------------------  --------------------
A                   17-percent          43-percent decrease
                    decrease

B                   11-percent          35-percent decrease
                    decrease

C                   5-percent decrease  37-percent decrease

D                   Not available       77-percent decrease

E                   Not available       68-percent decrease

F                   Not available       Not available
------------------------------------------------------------
The downward employment trend at these six business units is
consistent with the findings of other studies on the private sector
defense industry workforce.  One report,\6 for example, showed that
defense-related private employment had declined from about 3.7
million workers in 1987 to about 2.7 million workers in 1993, which
represents a 26-percent employment decline over the period. 
According to that report, the 20 leading defense contractors had
experienced an average employment reduction of 22 percent between
1987 and 1993.  Other studies have projected a continuing downward
trend in defense employment over the next several years.  For
example, a report\7 prepared by the Logistics Management Institute
for the Defense Conversion Commission estimated that private sector
defense-related employment would likely decline by about 803,000
jobs, or 27 percent, from 1992 to 1997. 


--------------------
\5 Peak employment years varied from 1983 to 1989, and the latest
projected years varied from 1996 to 2001. 

\6 Backgrounder--The U.S.  Defense Industry in 1993:  A Year-End
Review, Defense Budget Project (Jan.  17, 1994). 

\7 The DOD Drawdown:  Planned Spending and Employment Cuts, Logistics
Management Institute (Jan.  1993). 


      DECLINES IN IR&D/B&P
      EXPENDITURES
---------------------------------------------------------- Letter :5.2

Similar to the reductions in employment levels, the six business
units had made substantial cuts in their IR&D/B&P expenditures. 
Between their peak spending years\8 and 1993, these units had reduced
IR&D/B&P expenditures ranging from 31 percent to 71 percent and
projected reductions ranging from 41 percent to 84 percent through
the latest year projected.  Figure 4 shows the actual and projected
reductions. 

   Figure 4:  Actual and Projected
   Reduction in IR&D/B&P
   Expenditures

   (See figure in printed
   edition.)

The six business units' forecasts show that they plan to spend an
average of 54 percent less for IR&D/B&P than they spent during the
mid-to-late 1980s.  However, as shown in table 4, two of the business
units projected future expenditures for IR&D/B&P to be more than they
spent in 1976.  Two other business units forecasted their future
expenditures to be more than they spent in 1980. 



                           Table 4
           
              Comparison of Forecasted IR&D/B&P
            Expenditures With Expenditures in 1976
                           and 1980


                    1976 through last   1980 through last
Business unit       year forecasted     year forecasted
------------------  ------------------  --------------------
A                   9-percent increase  52-percent decrease

B                   4-percent decrease  15-percent decrease

C                   28-percent          43-percent decrease
                    increase

D                   Not available       45-percent increase

E                   Not available       7-percent increase

F                   Not available       Not available
------------------------------------------------------------
Several studies showed a correlation between the level of defense
expenditures and the amounts contractors spend on IR&D.  One study,\9
for example, stated that the level of defense procurement directly
affects IR&D activities, which are supported to a large extent by
overhead charges in production contracts.  The report stated that
when large production runs were the rule, many companies willingly
invested their own funds in IR&D because they could reasonably expect
to recover their investment.  Another report\10 predicted that, with
fewer defense procurements, IR&D payments would decrease and
companies might not be willing to risk conducting their own IR&D. 

To determine whether these reports applied to the business units we
visited, we compared the changes in the business units' spending
levels for IR&D/B&P with changes in their sales.  For four of the six
business units, we found that changes in IR&D/B&P expenditures
generally correlated to their sales volume.  For illustration
purposes, figure 5 compares the trend in one business unit's sales
and its IR&D/B&P expenditures. 

   Figure 5:  Percent Change in
   Sales and IR&D/B&P Expenditures

   (See figure in printed
   edition.)

Note:  Figures for years 1994 through 1997 are estimates. 

Because of concerns that the quantity and quality of IR&D would
decline as budget cuts forced the defense industry to limit overhead
costs, the Congress made substantial legislative revisions\11

to the IR&D program in fiscal years 1991 and 1992 to encourage
defense contractors to continue IR&D activities.  Even with these
revisions, defense contractors have continued to cut their IR&D/B&P
expenditures, as their defense sales have declined. 


--------------------
\8 Peak IR&D/B&P expenditure years varied from 1984 to 1988, and the
latest projected years varied from 1997 to 2001. 

\9 "The Future of the Defense-Related Industrial Base in the United
States", Parameters, Journal of the U.S.  Army War College (Summer
1994). 

\10 Defense R&D in the 1990s, Congressional Research Service Issue
Brief (Feb.  24, 1994). 

\11 In this legislation, the Congress (1) broadened the criteria for
allowable IR&D efforts to include any work of "potential interest" to
DOD; (2) removed all negotiated ceilings on allowable costs,
mandating an automatic 5-percent increase in pre-existing ceilings
through the end of fiscal year 1995 with full reimbursement of DOD's
share of incurred IR&D costs beginning in fiscal year 1996; and (3)
eliminated mandatory on-site technical reviews of industry projects
and abolished the formal mechanisms by which DOD could appraise and
score industry's IR&D efforts. 


      REDUCTIONS IN CAPITAL
      EXPENDITURES
---------------------------------------------------------- Letter :5.3

The six business units we visited have significantly cut their
capital expenditures from their peak spending levels in the 1980s.\12
The units had made reductions through 1993 ranging from 52 percent to
92 percent and estimated reductions ranging from 55 percent to 85
percent through the latest projected year.  The units projected a
weighted average reduction of 76 percent in their capital
expenditures.  Figure 6 shows the actual and projected reductions in
capital expenditures. 

   Figure 6:  Actual and Projected
   Reduction in Capital
   Expenditures

   (See figure in printed
   edition.)

Table 5 compares the business units forecasted expenditures with
their 1976 and 1980 expenditures.  When 1976 was used as the base
year, three business units projected higher capital expenditures in
the future, but when 1980 was used as a base year, one business unit
projected higher capital expenditures.  Similar to IR&D/B&P
expenditures, there is not a consistent trend in capital
expenditures.  For example, although Company A and Company C
projected higher capital expenditures compared to 1976, the companies
projected lower capital expenditures when compared to 1980.  However,
we found that changes in capital expenditures at three of the units
correlated to the units' sales volume. 



                           Table 5
           
               Comparison of Forecasted Capital
           Expenditures With 1976 and 1980 Capital
                         Expenditures


                    1976 through last   1980 through last
Business unit       year forecasted     year forecasted
------------------  ------------------  --------------------
A                   89-percent          53-percent decrease
                    increase

B                   493-percent         8-percent increase
                    increase

C                   75-percent          50-percent decrease
                    increase

D                   Not available       85-percent decrease

E                   Not available       78-percent decrease

F                   Not available       Not available
------------------------------------------------------------
Two business units had formal programs to limit future capital
expenditures.  One unit, for example, established the following four
categories in which proposed capital expenditures would be approved
by management: 

firm contractual commitments required to keep existing products
operational,

environmental requirements mandated by law,

health and safety requirements to meet Occupational Safety and Health
Administration standards, and

new product requirements for specific new products. 

According to a report issued in May 1989 by the Center for Strategic
and International Studies, the best measure of the U.S.  defense
industrial base's ability to maintain its technological lead is the
amount of capital spending in industry to expand capacity or improve
productivity. 


--------------------
\12 Peak capital expenditure years varied from 1980 to 1988, and the
latest projected years varied from 1997 to 2001. 


      REDUCTIONS IN FACILITIES
---------------------------------------------------------- Letter :5.4

Measured from their peak years,\13 five of the business units had
reduced their total square footage by as much as 34 percent through
1993, and five units projected reductions ranging from 6 percent to
43 percent, or an average of 26 percent, through the latest projected
year.  The units projected most of these reductions in their leased
space.  Figure 7 shows the actual and projected reductions in total
square footage. 

   Figure 7:  Actual and Projected
   Reductions in Facilities

   (See figure in printed
   edition.)

Despite the past and planned reductions in space occupied, most of
the units projected larger square foot usage than in 1976 and 1980. 
Table 6 compares the changes in the size of the business units'
facilities. 



                           Table 6
           
            Comparison of Forecasted Total Square
              Footage With 1976 and 1980 Square
                           Footage


                    1976 through last   1980 through last
Business unit       year forecasted     year forecasted
------------------  ------------------  --------------------
A                   65-percent          29-percent increase
                    increase

B                   62-percent          31-percent increase
                    increase

C                   15-percent          14-percent increase
                    increase

D                   Not available       34-percent decrease

E                   Not available       11-percent increase

F                   Not available       Not available
------------------------------------------------------------
Three business units expected to use more square footage in the
future\14 than occupied in 1976; four units expected to use more
space than they occupied in 1980.  According to Defense Contract
Management Command records, defense contractors have significantly
reduced the size of their facilities through such actions as vacating
and selling buildings and terminating leases. 


--------------------
\13 Peak square footage years varied from 1985 to 1991, and the
latest projected years varied from 1997 to 2001. 

\14 The latest projected years varied from 1997 to 2001. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :6

We compiled and compared information on the declines and buildups in
defense expenditures since the end of World War II.  We also
conducted literature searches and examined various reports,
assessments, and other documents to determine how defense contractors
throughout the industry have been affected by reduced defense
spending. 

The business units provided us with data on their sales, employment
levels, capital expenditures, IR&D/B&P, and facilities for 1976
through the latest projected year.  We focused our work on these five
elements because we believed they were most representative of the
impact of reduced defense spending on defense contractor business
units. 

For three of the business units, we were unable to obtain data as
early as 1976 and therefore used the earliest data available.  We
accepted the data provided by the business units and did not attempt
to validate the data.  In some cases, the organization of the
business units have changed since 1976, and the units had to compile
or estimate data to reflect their organization since that time. 

We conducted our review from March 1994 to January 1995 in accordance
with generally accepted government auditing standards.  We did not
obtain DOD comments on this report; however, we discussed the results
of our work with contractor representatives from each of the six
business units. 


---------------------------------------------------------- Letter :6.1

We are sending copies of this report to the Secretary of Defense,
officials of the six business units, and other 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.  The major contributors to this
report were John K.  Harper, George C.  Burdette, Anne-Marie Olson,
and Amy S.  Parrish. 

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

