Overhead Costs: Defense Industry Initiatives to Control Overhead Rates
(Letter Report, 05/03/95, GAO/NSIAD-95-115).
Pursuant to a congressional request, GAO reviewed initiatives taken by
six defense contractors to reduce overhead costs, focusing on whether
the contractors' actions would avoid increasing overhead rates.
GAO found that: (1) declining defense spending has resulted in reduced
sales by defense contractors; (2) at six defense contractors, sales
declined by an average of 39 percent between the peak years and 1993 and
were projected to decline an average of 55 percent from 1995 to 2001;
(3) in response to declining business, contractors reduced their
overhead costs by reducing the number of indirect employees, cutting
facilities, and reducing independent research and development and bid
proposal expenses; (4) some defense contractors predicted increases in
their overhead rates, because their overhead costs were not declining as
rapidly as their sales; and (5) increasing overhead rates without
increasing sales could result in increased procurement costs.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: NSIAD-95-115
TITLE: Overhead Costs: Defense Industry Initiatives to Control
Overhead Rates
DATE: 05/03/95
SUBJECT: Department of Defense contractors
Defense contracts
Defense procurement
Overhead costs
Cost control
Fringe benefits
Reductions in force
Budget cuts
Contractor personnel
Research and development costs
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Cover
================================================================ COVER
Report to Congressional Requesters
May 1995
OVERHEAD COSTS - DEFENSE INDUSTRY
INITIATIVES TO CONTROL OVERHEAD
RATES
GAO/NSIAD-95-115
Overhead Costs
Abbreviations
=============================================================== ABBREV
DCMC - Defense Contract Management Command
DOD - Department of Defense
IR&D/B&P - independent research and development and bid and
proposal
Letter
=============================================================== LETTER
B-260357
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
Senior Department of Defense (DOD) officials have expressed concern
that contractor overhead rates may drive up procurement costs as a
result of declines in DOD spending. In accordance with a September
26, 1994, request from the former Chairman and Ranking Minority
Member, we reviewed (1) initiatives taken by six individual business
units of large defense contractors to reduce overhead costs and (2)
the issue of whether the units' actions would avoid increases in
overhead rates.
We selected business units of General Dynamics, General Motors,
Lockheed, Martin Marietta, McDonnell Douglas, and United
Technologies. The six units we visited were primarily engaged in
defense work, and their sales comprised an important part of the
parent corporations' total government sales.\1 To protect proprietary
data, we have not identified the six business units we visited.
Also, we frequently interchanged the business unit labels (A-F)
throughout the report to further ensure the protection of proprietary
data. While not projectable to the defense industry, the six units'
actions provide some insight into measures taken to control overhead
rates.
--------------------
\1 Includes sales made to foreign governments through the U. S.
government.
BACKGROUND
------------------------------------------------------------ Letter :1
DOD has estimated that overhead costs on average represent about
one-third of a contract's price. However, these costs vary from
contractor to contractor and from industry to industry. Examples of
costs that are typically classified as overhead, because these costs
are not directly assignable to a specific contract but rather support
a company's total business, include those of facilities and
equipment, administrative and general office support, computer
operations, managers' salaries, and security. Overhead costs are
generally accumulated by logical groupings referred to as overhead
cost pools. Manufacturing,\2 engineering,\3 and general and
administrative\4 overhead costs are commonly grouped in separate cost
pools. Contractors also commonly use separate pools for material,
tooling, selling, and off-site labor costs. Overhead rates are
computed by dividing the overhead cost pools by a common base such as
total direct labor dollars, total labor hours, or total costs. The
overhead rates are then used to allocate a company's overhead costs
to its contracts.
Because overhead costs are significant, senior DOD acquisition
officials have expressed concern that the sharp decline in defense
spending would lead to increases in contractor overhead rates and, in
turn, increases in the cost of individual defense programs. In
February 1992, for example, the Army's Senior Acquisition Executive
noted that declining defense budgets would result in fewer programs
and that, for most defense contractors, this would mean a
significantly smaller business base against which to charge overhead.
This condition, according to the executive, would drive up
contractors' overhead rates and could result in increases or even
overruns in program costs.
In September 1992, the Secretary of the Air Force directed that
overhead should-cost reviews\5 be conducted at contractors
responsible for the F-22 fighter aircraft program because overhead
costs on that program had increased by several hundred million
dollars. In addition, a 1993 Defense Science Board Task Force report
recognized that the rapid loss of defense sales would likely lead to
significant increases in defense contractor overhead rates. The task
force noted that increases in overhead rates could lead to unexpected
and largely unavoidable cost increases in existing programs, even if
aggressive actions were taken to cut overhead costs.\6
--------------------
\2 Manufacturing overhead embodies all items of production cost,
except direct materials, direct labor, and other direct costs.
\3 Engineering overhead includes the cost of directing and supporting
an engineering department's activities.
\4 General and administrative overhead includes the expenses of a
company's general and executive offices; the costs of such staff
services as legal, accounting, public relations, financial, and
similar functions; and the cost of other miscellaneous activities
related to the overall business.
\5 These reviews are a special form of a cost analysis that is used
to evaluate the economy and efficiency of a contractor's overhead
operations.
\6 FY 1994-99 Future Years Defense Plan, Defense Science Board Task
Force (May 1993).
RESULTS IN BRIEF
------------------------------------------------------------ Letter :2
Declining defense spending since the late 1980s has resulted in
reduced sales by defense contractors and a concurrent reduction in
the business bases against which they charge overhead. At the six
business units we visited, for instance, sales declined by an average
of 39 percent between the peak years and 1993 and were projected to
fall by an average of 55 percent between the peak years and latest
projected years. However, in response to their declining business
bases, the business units had taken action to reduce their overhead
costs. Specifically, the six units reduced their overhead costs by
an average of 35 percent between their peak years and 1993 and were
anticipating on average a total reduction of 53 percent between their
peak years and latest projected years. To reduce overhead costs, the
business units had taken measures such as reducing the number of
indirect employees,\7 cutting employee health care benefits,
consolidating facilities, and reducing independent research and
development and bid and proposal (IR&D/B&P\8 expenditures.
Despite these efforts, overhead costs at four of the six business
units were not declining as rapidly as their sales; thus, these units
were forecasting increases in their overhead rates. One unit, for
example, was projecting the overhead rate to increase by 17 percent
in real terms between 1993 and 2001. This means the business unit
charged $1.50 in overhead costs for every one dollar in direct labor
in 1993, but will charge $1.76 in overhead costs for every one dollar
in direct labor by 2001. Unless these four business units can
identify additional cost reductions or increase their sales, their
overhead rates will continue to rise--a condition that could result
in increased procurement costs.
--------------------
\7 Employees are referred to as "indirect employees" when their work
cannot be identified with a specific cost objective but rather
supports several cost objectives. The cost of indirect employees is
therefore charged to overhead accounts and allocated to all
contracts.
\8 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 expenditures are costs incurred in preparing,
submitting, and supporting bids and proposals (solicited and
unsolicited) on potential government or nongovernment contracts.
DEFENSE SPENDING IS DECLINING
------------------------------------------------------------ Letter :3
The decline in defense spending since the late 1980s has eroded the
business bases against which contractors charge overhead. Total DOD
outlays,\9 or expenditures, have fallen from a high of $354.1\10
billion in fiscal year 1989 to $274.5 billion in fiscal year 1994--a
$79.6-billion decrease. The executive branch is projecting an
additional decrease of $50.0 billion in defense expenditures by
fiscal year 2000. This would represent a total decrease of $129.6
billion, or about 37 percent, between fiscal years 1989 and 2000.
More important to defense contractors, however, is that outlays for
the procurement account have fallen even more sharply than total
outlays. As shown in figure 1, procurement outlays are projected to
decline from a peak of $104.9\11 billion in fiscal year 1987 to $44.4
billion by fiscal year 2000--a reduction of about 58 percent. The
procurement account is important to defense contractors because it is
the funding source for the products they sell--weapons and
components, communication and support equipment, munitions, and other
related items.
Figure 1: DOD Procurement
Outlays
(See figure in printed
edition.)
Notes: Constant year 1995 dollars.
Figures for fiscal years 1995-2000 are executive branch projections.
Since 1991, DOD has canceled, terminated, or reduced the production
of a large number of existing and planned weapons. According to a
1993 report,\12 defense contractors are increasingly experiencing the
impact of these actions. The six business units we visited were
particularly sensitive to changes in defense spending because U.S.
government sales\13 accounted for an average of 94 percent of their
total 1993 sales. As a result, the reduction in defense spending has
significantly eroded their business bases. As shown in table 1,
sales at the six business units we visited had declined by an average
of 39 percent between the peak year\14 and 1993. Moreover, the units
were projecting their sales to decrease by an average of 55 percent
between the peak year and the latest year for which they had made
sales projections at the time of our visits--from 1997 to 2001
depending on the unit.
Table 1
Actual and Projected Declines in Sales
Based on Constant Year 1995 Dollars
(In percent)
Peak year through
Peak year through last projected
Business unit 1993 year
-------------------- ------------------ ------------------
A 29 62
B 36 50
C 54 51
D 42 55
E 48 62
F 21 73
Weighted average 39 55
------------------------------------------------------------
--------------------
\9 DOD outlays generally represent cash payments and in a given
fiscal year may represent the liquidation of obligations incurred
over a number of years.
\10 DOD outlays are stated in constant year 1995 dollars.
\11 DOD's procurement outlays are stated in constant year 1995
dollars.
\12 Adjusting to the Drawdown: The Transition in the Defense
Industry, Defense Budget Project (April 1993).
\13 Includes sales made to foreign governments through the U.S.
government.
\14 Peak sales years for the six business units varied from 1985 to
1989.
SIGNIFICANT REDUCTIONS MADE IN
TOTAL OVERHEAD COSTS
------------------------------------------------------------ Letter :4
The six business units we visited had significantly reduced their
actual and projected overhead costs. Some of the reduction can be
attributed to declines in the units' business bases. However, the
business units have taken aggressive steps to reduce overhead costs
to remain competitive in an environment of declining sales. As shown
in table 2, the six units have reduced their overhead costs by an
average of 35 percent between the peak year\15 and 1993. They plan
to reduce overhead costs by an average of 53 percent between the peak
year and the latest projected year.\16
Table 2
Actual and Projected Reductions in
Overhead Based on Constant Year 1995
Dollars
(In percent)
Peak year through
Peak year through last projected
Business unit 1993 year
-------------------- ------------------ ------------------
A 25 32
B 40 62
C 63 69
D 41 53
E 11 67
F 30 39
Weighted average 35 53
------------------------------------------------------------
--------------------
\15 Peak overhead years varied from 1985 to 1989.
\16 Projected overhead costs are presented for the latest year
forecasted by the business units at the time of our visits--from 1995
to 2001.
OVERHEAD COST REDUCTION
INITIATIVES IMPLEMENTED
------------------------------------------------------------ Letter :5
To reduce overhead costs, the business units targeted top overhead
cost drivers such as indirect labor, fringe benefits, and facilities
and assessed other areas of their overhead operations to identify
additional cost reduction opportunities. The cost reduction measures
initiated by both the business units and their corporate
headquarters, which are shown in
table 3, resulted in significant reductions in overhead costs. The
initiatives are discussed in greater detail in appendix I.
Table 3
Areas of Cost Reduction Initiatives
Initiative A B C D E F
------------------ ----- ----- ----- ----- ----- -----
Indirect labor X X X X X X
Fringe benefits X X X X X X
Facilities X X X X X
IR&D/B&P X X X X X X
expenditures
Employee X X X X X X
compensation
Data processing X X X X X
costs
Employee savings X X X X
plans
Property taxes X X
------------------------------------------------------------
According to information collected by the Defense Contract Management
Command (DCMC), the DOD organization primarily responsible for
overseeing contractor overhead costs, similar cost reduction
initiatives are being pursued by major contractors throughout the
defense industry. Some of these initiatives have resulted in
significant overhead cost reductions. One of the business units we
visited, for example, expects to avoid more than $1 billion in costs
from 1989 through 1996 by reducing indirect personnel by laying off
employees, contracting out at lower rates, using part-time security
guards, training salaried employees after hours, and reducing
duplicate functions (see fig. 2).
Figure 2: Indirect Labor Cost
Reduction in One Business Unit
(See figure in printed
edition.)
OVERHEAD RATES CONTINUE TO RISE
DESPITE COST REDUCTIONS
------------------------------------------------------------ Letter :6
Even though the business units we visited had taken measures to
reduce their overhead costs, these costs were not declining as
rapidly as the business bases at four of the business units. As a
result, these units were projecting increases in their overhead
rates. To assess the significance of these projections, we computed
composite\17 overhead rates from 1993 to the last year forecasted.\18
Business unit officials generally agreed that our composite rates
reflected the overall trend in their individual overhead rates and
provided a useful evaluation tool. As shown in table 4, four
business units will experience increases in their overhead rates from
1993 as the base year. Two of these increases are substantial.
Table 4
Percentage of Change in Composite
Overhead Rates
1993 through last projected
Business unit year
----------------------------- -----------------------------
A 9-percent increase
B 16-percent increase
C 17-percent increase
D 4-percent decrease
E 6-percent increase
F 7-percent decrease
------------------------------------------------------------
Because overhead rates are used to allocate a company's overhead
costs to government contracts, increases in these rates could cause
the cost of individual defense programs to increase, a concern shared
by senior DOD officials. The Secretary of Defense, for example, has
pointed out that as orders for defense systems decrease, defense
contractors must decrease their overhead because failure to do so
could result in prohibitive increases in unit costs, severely
hampering DOD's ability to modernize.
--------------------
\17 The composite rates were computed by dividing total overhead
costs by either a direct labor base or a total cost base, with
concurrence from unit officials.
\18 The last year of overhead rates forecasted by the business units
at the time of our visits varied from 1995 to 2001.
SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7
At the six business units we visited, we obtained information on
actual and forecasted business bases, total overhead costs, and
overhead cost reduction initiatives. To assess the impact of the
cost reduction initiatives on overhead rates, we analyzed trends in
the business units' engineering, manufacturing, and general and
administrative overhead rates. We also computed composite overhead
rates to assess the overall trends in projected overhead rates and
the potential cost impact on DOD contracts.
We discussed the business units' cost reduction initiatives and
projected overhead rates with unit officials, as well as with DOD
contract administration and contract audit representatives at each of
the units. In addition, we examined various reports, papers, and
other documents on contractor overhead costs and rates throughout the
industry. We did not obtain DOD comments on the report; however, we
discussed the results of our review with business unit officials and
incorporated their comments as appropriate. We performed our review
from March 1994 to January 1995 in accordance with generally accepted
government auditing standards.
---------------------------------------------------------- Letter :7.1
We are sending copies of this report to the Secretary of Defense,
officials at the six business units we visited, and other interested
congressional committees. Copies of this report will also be made
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.
OVERHEAD COST REDUCTION
INITIATIVES
=========================================================== Appendix I
The six business units we visited have taken initiatives to reduce
overhead costs in the environment of declining defense business.
These initiatives have resulted in significant reductions in overhead
costs. Overhead costs such as indirect labor, fringe benefits, and
facility costs were considered top overhead cost drivers, and we
found that the six business units we visited were taking measures to
reduce these costs. Besides focusing on their primary overhead cost
drivers, the business units were also reducing other overhead costs.
Based on information the Defense Contract Management Command (DCMC)
had collected, the cost reduction initiatives by these six units
generally appeared to be representative of the kind of actions being
taken by major defense contractors throughout the industry.
REDUCTION IN NUMBER OF INDIRECT
PERSONNEL
--------------------------------------------------------- Appendix I:1
Each of the business units we visited have significantly reduced the
number of indirect personnel as part of their cost reduction
initiatives. As shown in figure I.1, five\1 of the business units
achieved reductions in indirect personnel ranging from 43 percent to
77 percent between their peak year employment\2 and 1993. In
addition, the units were projecting total reductions ranging from 51
percent to 82 percent from peak employment years to the latest
projected year.\3
Figure I.1: Actual and
Projected Reductions in
Indirect Personnel
(See figure in printed
edition.)
Such reductions resulted in significant overhead cost savings because
indirect labor was a top cost driver at five of the business units we
visited. One unit, for instance, estimated it had saved $40 million
in salaries and fringe benefit costs by reducing indirect personnel
by approximately
600 over a 2-year period.
Major personnel reductions have also occurred throughout the defense
industry. According to a DCMC assessment that included 20
contractors, contractors have made significant reductions in their
direct and indirect employees since 1990. DCMC data showed, for
example, that two major defense contractors expected to save almost
$1 billion in salary and fringe benefit costs from 1991 through 1994
as a result of reducing the number of their employees.
--------------------
\1 One of the six business units had records that did not contain a
readily available breakout of direct and indirect employees.
\2 Peak indirect employment years varied from 1981 to 1987.
\3 The latest projected years for indirect employment varied from
1996 to 2001.
CHANGE IN EMPLOYEE FRINGE
BENEFITS
--------------------------------------------------------- Appendix I:2
At the six business units we visited, fringe benefits, particularly
health care costs, were also among the top overhead costs drivers.
To reduce health care costs, the business units increased employee
deductibles, raised co-payments, used preferred provider networks and
health maintenance organizations, and implemented flexible benefit
programs. DCMC data showed that other major defense contractors were
taking similar actions in the health care area.
Officials at one business unit we visited indicated that they expect
to save 35 percent to 40 percent on health care costs (hospital and
physician services) by using preferred provider networks with
agreed-to fee schedules. This business unit also has shifted some of
the health care costs to its employees by increasing employee
contributions by 50 percent. In addition, this business unit has
begun to promote early diagnosis and prevention to avoid future
costs. As shown by figure I.2, this business unit expects to achieve
a cost avoidance of over $3,000 per employee, or a total of $79.9
million, between 1991 and 1996 as a result of its health care cost
reduction initiatives.
Figure I.2: Reduction in
Health Care Costs Per Employee
(See figure in printed
edition.)
Another business unit we visited reduced its workers' compensation
costs by about $28 million through special work assignments,
pharmaceutical discounts, and a medical utilization program to assure
appropriate treatment is rendered. The DCMC data showed that other
major defense contractors were also taking action to reduce workers'
compensation costs.
CONSOLIDATION OF FACILITIES
--------------------------------------------------------- Appendix I:3
Facility costs were another top overhead cost driver. Five of the
six business units visited had reduced their total square footage by
as much as 34 percent between their peak year\4 and 1993 by disposing
of both owned and leased space. In addition, the units were
projecting reductions in their total square footage ranging from 6
percent to 43 percent between the peak year and latest projected
year.\5 The data collected by DCMC showed that other major defense
contractors were also reducing and consolidating their facilities.
According to the DCMC data, one defense contractor has saved $95
million since 1988 by reducing the amount of leased facilities in
high cost areas. Figure I.3 shows the results of the facility
consolidation efforts of one of the business units we visited.
Figure I.3: Consolidation of
Owned and Leased Facilities
(See figure in printed
edition.)
By reducing owned and leased square footage, the business units we
visited had also reduced facility-related costs such as cafeteria
expenses, security costs, maintenance costs, property taxes,
insurance, rental costs, electricity, fuel, water, and sewage. One
unit estimated it would save about $10 million a year between 1987
and 1996 by eliminating these type costs.
--------------------
\4 Peak years for square footage varied from 1985 to 1991.
\5 The latest year of projected square footage available at the time
of our visits varied from 1997 to 2001.
REDUCTION IN INDEPENDENT
RESEARCH AND DEVELOPMENT AND
BID AND PROPOSAL EXPENDITURES
--------------------------------------------------------- Appendix I:4
The business units we visited had made reductions in their
independent research and development and bid and proposal (IR&D/B&P)
expenditures ranging from 31 percent to 71 percent between their peak
years\6 and 1993. At the time of our visits, the units were
projecting total reductions in IR&D/B&P costs ranging from 41 percent
to 84 percent between their peak years and latest projected years.\7
Figure I.4 shows the business units' actual and projected reductions
in IR&D/B&P expenditures.
Figure I.4: Actual and
Projected Percentage Reduction
in IR&D/B&P Expenditures
(See figure in printed
edition.)
One business unit we visited indicated that its IR&D/B&P expenditure
level was consistent with the expected reduction in the future
defense budget. An official of the business unit advised us that the
unit plans to assess the level of research and development investment
in relation to its other overhead allocations on an annual basis.
The official indicated that the benefit from those research and
development expenditures will be weighed against the company's
overall rate structure and cost competitiveness. Another business
unit planned to increase its emphasis on long-term technology
development. According to a representative from this unit, the
reduction in forecasted IR&D/B&P expenditures is consistent with the
forecast of declining defense business.
--------------------
\6 Peak IR&D/B&P years varied from 1984 to 1988.
\7 The latest projected years for IR&D/B&P expenditures varied from
1997 to 2001.
REDUCTION IN EMPLOYEE
COMPENSATION
--------------------------------------------------------- Appendix I:5
The six business units we visited had controlled salary and labor
costs by using lump sum payments instead of merit wage or salary
increases or by limiting salary and wage increases. This action
eliminated the effect of compounding on future wages and wage-related
fringe benefits. As a result, one business unit expected to save
approximately $34.7 million over a 9-year period. In addition to
this action, another business unit eliminated overtime premiums for
salaried employees, which reduced costs by $11.4 million from 1990 to
1993. DCMC found that other major defense contractors were making
changes to their employees' compensation, including instituting
salary and wage freezes, to reduce costs.
DATA PROCESSING COST REDUCTION
--------------------------------------------------------- Appendix I:6
Five of the six business units we visited had initiated measures to
reduce data processing costs, including transitioning to low-cost
data processing alternatives, consolidating mainframe computing
capabilities, and contracting out data processing operations. One
business unit expected to realize a savings of about $27 million over
a 5-year period by consolidating two of its mainframe data centers.
According to data being collected by DCMC, other defense contractors
have taken similar actions to reduce data processing costs.
CHANGES TO EMPLOYEE SAVINGS
PLANS
--------------------------------------------------------- Appendix I:7
Four of the business units we visited had changed their employee
savings plans to reduce overhead costs. One business unit
temporarily reduced company matching contributions to the savings
plan by 50 percent, resulting in a savings of about $22 million.
According to the DCMC data, other top defense contractors were taking
similar actions. The DCMC data showed, for example, that one
contractor funded the administrative costs of its employee savings
plan through employee contributions, which has saved the contractor
an estimated $3 million.
PROPERTY TAX REDUCTION
--------------------------------------------------------- Appendix I:8
Two of the business units we visited had initiated cost reduction
actions with their local governments. One unit achieved a $1-million
a year cost reduction by demonstrating lower market values for its
plant sites based on marketability, building condition, and
occupancy. The other unit hired an outside consultant to assess its
property because it believed the county was overstating the property
assessment value. At the time of our visit, the unit was still
pursuing the issue with the county.
OTHER COST REDUCTION
INITIATIVES
--------------------------------------------------------- Appendix I:9
The business units we visited have taken a number of other measures
to reduce their overhead costs. One unit, for instance, renegotiated
its janitorial contract to reduce the number of trash collections and
cleanings as part of its continual process of seeking new ways to cut
overhead cost. The cleaning services contractor was making fewer
daily pickups of sanitary waste and was focusing on removing
time-sensitive trash, such as wet or organic matter, which enabled
the contractor to use its resources more efficiently and not adhere
to the rigid or daily schedules previously used. The unit expected
to save about $200,000 annually. According to DCMC information,
other major Department of Defense contractors were targeting waste
reduction as a means of cost containment.
Another cost reduction initiative was to contract out various aspects
of the units' operations. One unit expected to save $5 million over
a 5-year period by contracting out its cafeteria operations.
According to the DCMC data, other major defense contractors have also
contracted out parts of their operations to reduce their overhead
costs.