Defense Budget: Capital Asset Projects Undergo Significant Change Between
Approval and Execution (Letter Report, 12/28/94, GAO/NSIAD-95-20).

The Defense Department (DOD) continues to experience major problems in
managing its capital asset program and carrying out its capital budget.
Capital assets include such items as equipment, minor construction, and
management information systems.  The activities GAO visited, for
example, canceled 86 percent and 65 percent of the projects in their
fiscal year 1993 and 1994 capital budgets, respectively.  GAO's analysis
of 56 fiscal year 1994 projects at six defense activities showed that
many cancellations were due to weaknesses in the budget justification
and preparation process.  The uncertainty caused by base closings and
realignments, budget cuts, and other DOD management initiatives also
contributed to project cancellations. DOD has developed new guidance
that, if properly implemented, will strengthen the Defense Business
Operations Fund's capital budgeting process.  Developing new procedures,
however, is only the first step.  These are long-standing problems that
have been highlighted repeatedly by GAO, the Inspectors General, and
service audit agencies.  High-level management attention, training, and
appropriate oversight are needed to ensure that key managers fully
understand and implement the new guidance.  One such mechanism would be
to include capital asset program deficiencies in the Federal Managers'
Financial Integrity Act report.

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

 REPORTNUM:  NSIAD-95-20
     TITLE:  Defense Budget: Capital Asset Projects Undergo Significant 
             Change Between Approval and Execution
      DATE:  12/28/94
   SUBJECT:  Defense procurement
             Strategic planning
             Defense budgets
             Cost effectiveness analysis
             Oversight by Congress
             Capital
             Revolving funds
             Industrial funds
             Investments
             Mission budgeting
IDENTIFIER:  Defense Business Operations Fund
             DOD Asset Capitalization Program
             
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Cover
================================================================ COVER


Report to Congressional Requesters

December 1994

DEFENSE BUDGET - CAPITAL ASSET
PROJECTS UNDERGO SIGNIFICANT
CHANGE BETWEEN APPROVAL AND
EXECUTION

GAO/NSIAD-95-20

Defense Budget


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

  DBOF - Defense Business Operations Fund
  DOD - Department of Defense
  OMB - Office of Management and Budget
  OSD - Office of the Secretary of Defense

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


B-257625

December 28, 1994

The Honorable Sam Nunn
Chairman
The Honorable Strom Thurmond
Ranking Minority Member
Committee on Armed Services
United States Senate

The Honorable Carl Levin
Chairman, Subcommittee on Oversight of
 Government Management
Committee on Governmental Affairs
United States Senate

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

The Department of Defense (DOD) is responsible for informing the
Congress about its capital asset needs in an annual Defense Business
Operations Fund (DBOF) capital budget.\1 Capital assets include such
things as equipment, minor construction, and management information
systems.  In fiscal year 1994, the DBOF capital budget totaled $1.8
billion. 

Concerned about apparent discrepancies between the DBOF capital
budget and actual capital asset spending, the Chairman, Subcommittee
on Oversight of Government Management, Senate Committee on
Governmental Affairs, asked us to (1) determine if DOD carries out
the projects identified in the capital budget and (2) assess the
effectiveness of DOD's capital budget preparation and review process. 
The House and Senate Committees on Armed Services (in the Conference
Report on the fiscal year 1994 National Defense Authorization Act)
also required us to determine the extent that DOD carries out the
DBOF capital budget. 


--------------------
\1 In fiscal year 1992 DOD consolidated several stock and industrial
revolving funds, plus other selected business operations, into a
single revolving fund called DBOF. 


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

DOD continues to experience significant problems in managing its
capital asset program and carrying out its capital budget.  The
activities we visited, for example, canceled 86 percent and 65
percent of the projects in their fiscal year 1993 and 1994 capital
budgets, respectively.  Our analysis of
56 fiscal year 1994 projects at 6 defense activities showed that a
large number of cancellations occurred because of weaknesses in the
budget justification and preparation process.  The uncertain
environment caused by base closings and realignments, budget
reductions, and other DOD management initiatives also contributed to
project cancellations.  Because activity managers usually replaced
the canceled projects with others, the projects carried out by the
six activities bear little resemblance to those in the capital budget
submitted to the Congress. 

DOD has developed new guidance that, if properly implemented, will
strengthen the DBOF capital budgeting process.  This guidance is a
step in the right direction but can be improved by requiring
activities to (1) closely link their capital investment decisions to
long-range activity plans and missions and (2) rely on net present
value as the primary investment decision criterion for rank ordering
competing capital investment projects. 

Developing new procedures, however, is only a first step.  These are
long-standing problems that have been reported many times by us, the
Inspectors General, and service audit agencies.  High-level
management attention, training, and appropriate oversight mechanisms
are necessary to ensure that key managers fully understand and
implement the new guidance.  One such mechanism is to include capital
asset program deficiencies in the Federal Managers' Financial
Integrity Act report.  This elevates the significance of the
deficiencies and requires special management oversight and tracking. 


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

In fiscal year 1992, DOD consolidated nine industrial and stock funds
into a single revolving fund called DBOF.\2 The establishment of DBOF
did not change any previous organizational reporting structure or
command authority relationship.  DOD consolidated cash management
activities, which helped reduce the amount of cash needed to operate
the funds, but functional and cost management responsibilities for
the industrial and stock funds remained with the military departments
and defense agencies. 

Modeled after private sector business operations, DBOF industrial and
stock fund activities have a contractual (buyer-seller) relationship
with their customers, primarily other elements in the military
departments and defense agencies.  These activities, for a fee,
provide such services as the overhaul of ships, tanks, and aircraft
and sell over 5 million types of vital inventory items, such as
landing gears and other aircraft parts.  Many of these items are
essential to maintaining the military readiness of weapon systems and
military personnel.  Activities within DBOF have assets reportedly
valued at $126 billion and expect fiscal year 1995 revenue of $77
billion, making them equivalent to one of the world's largest
corporations. 

When DBOF began in 1991, DOD reinstated a process where capital asset
investments costing more than $15,000 are purchased with revolving
funds rather than through direct appropriations.  DOD funds these
capital investments by including depreciation expenses in the prices
activities charge their customers.  If the amount of depreciation is
not sufficient to fully fund the investment program, DOD adds a
surcharge to the price.  Table 1 identifies the capital budgets for
fiscal years 1993 through 1995, along with the amount of the
surcharge added each year. 



                           Table 1
           
            Capital Asset Budget and Depreciation
                          Surcharges

                           Capital asset           Surcharge
Fiscal year            budget (billions)          (millions)
--------------------  ------------------  ------------------
1993                                $1.5               $40.9
1994                                 1.8                31.5
1995                                1.44             446.3\a
------------------------------------------------------------
\a DOD added the large fiscal year 1995 surcharge primarily to fund
the Joint Logistics Systems Center.  DOD considers this center a DBOF
capital investment because the bulk of its funding goes directly to
the development of DBOF-related financial and inventory management
systems. 

Although capital asset investments are financed through DBOF
revolving funds, DOD prepares and submits an annual DBOF capital
budget to the Congress, which identifies the projects each activity
will undertake during the fiscal year.  All projects costing $500,000
or more must be shown as separate line items and fully explained and
justified.  Items under $500,000, such as forklifts, trucks, and
trailers, must be equally justified but can be combined as one budget
line item for each business area. 

The DBOF Policy and Responsibilities Statement issued on September
27, 1991, and service-level guidance require the services and defense
agencies to justify all projects included in the capital budget sent
to the Congress.  Among other things, budget developers must document
the reasons for planned capital investment purchases and their
expected benefits.  This justification data should include the
workload projections the purchase is based on as well as the source
or rationale supporting the projections.  In addition, the benefits
of a capital project should be supported, depending on its dollar
value and purpose, by some type of cost or economic analysis.  The
statement also requires that this justification data be retained and
readily available for review, audit, or evaluation. 

Higher service and defense agency command levels review and
consolidate field activities' projects into budget submissions. 
These submissions are then sent to the DOD Comptroller for further
review and evaluation.  The Comptroller, in turn, consolidates the
budget submissions into the capital budget, which is sent to the
Congress. 


--------------------
\2 DBOF activities also include the following defense agencies: 
Defense Finance and Accounting Service, Defense Commissary Agency,
Defense Technical Information Center, Defense Reutilization and
Marketing Service, and Defense Industrial Plant Equipment Center. 


   LARGE PERCENTAGE OF CAPITAL
   PROJECTS ARE CANCELED OR
   POSTPONED
------------------------------------------------------------ Letter :3

The activities cited in tables 2 and 3 canceled or postponed 86 and
65 percent of the projects they included in the fiscal years 1993 and
1994 capital budgets, respectively.  The value of these projects was
$40.3 million in fiscal year 1993 (57 percent of the activities'
total capital budgets) and $35.5 million in fiscal year 1994 (47
percent).  Although the rate of cancellations and postponements
varied, the Army activities, by far, were the least successful in
carrying out their capital budgets.  Tables 2 and 3 summarize the
status of the fiscal years 1993 and 1994 capital budgets for the
activities we visited. 



                           Table 2
           
              Fiscal Year 1993 Cancellations and
                        Postponements

                    (Dollars in millions)


Activities
visited        Value  Number   Value  Number   Value  Number
------------  ------  ------  ------  ------  ------  ------
Army depot     $41.2     246   $28.5     225      69      91

 maintenance
 activity\a
Two Air         16.4      44     3.8      33      23      75
 Force
 activities
Two Navy        12.8      64     8.0      46      63      72
 activities
============================================================
Total          $70.4     354   $40.3     304      57      86
------------------------------------------------------------
\a Although we visited two Army maintenance depots at Letterkenny,
and Tobyhanna, Pennsylvania, we obtained statistics for all Army
maintenance depots. 



                           Table 3
           
              Fiscal Year 1994 Cancellations and
                        Postponements

                    (Dollars in millions)


Activities
visited        Value  Number   Value  Number   Value  Number
------------  ------  ------  ------  ------  ------  ------
Army depot     $35.7     109   $23.3      91      65      84
 maintenance
 activity\a
Two Air         25.5      82     6.4      39      25      48
 Force
 activities
Two Navy        14.0      42     5.8      22      41      52
 activities
============================================================
Total          $75.2     233   $35.5     152      47      65
------------------------------------------------------------
\a As in table 2, the data includes projects for all Army maintenance
depots, not just the two we visited at Letterkenny, and Tobyhanna,
Pennsylvania. 

When a project was canceled or postponed, officials at the six
activities we visited told us they usually substituted it with
another project.  The Air Force Materiel Command, for example, has
given the San Antonio Air Logistics Center reprogramming authority
for any project under $500,000.  Thus, when the DBOF capital budget
is approved and funding levels are established for San Antonio, the
local commander has the discretion to use that money for any capital
project, not just those in the capital budget.  In the fiscal year
1994 capital budget for the San Antonio Air Logistics Center, 77 of
the 82 projects were less than $500,000. 

Even though the Air Force Systems Command directed the San Antonio
Air Logistics Center to keep documentation showing why projects are
canceled, local managers at the Center were not clear about these
requirements.  As a result, some files for canceled projects had been
discarded and others were missing justification documents. 
Therefore, in many cases, we were unable to determine why a project
was canceled or postponed. 

The Navy activities we visited had similar authority to cancel and
substitute capital projects under $500,000.  The Army activities, on
the other hand, needed approval to cancel a project and substitute it
with another.  This approval, however, was not hard to obtain, as
evidenced by the large percentage of canceled projects at the Army
maintenance depots. 

DOD officials acknowledged that DBOF activities have not always
executed the capital asset program as planned.  To address this
problem, DOD specifically listed the capital asset projects
authorized for execution in the fiscal year 1994 annual operating
budgets that were issued to the DBOF activities.  The services and
DOD components must report any deviation from the approved capital
asset program to the DOD Comptroller's Office.  This initiative could
help improve program execution. 


   POOR JUSTIFICATION PROCESS AND
   OTHER FACTORS CAUSED
   CANCELLATIONS AND POSTPONEMENTS
------------------------------------------------------------ Letter :4

To determine why such a large percentage of projects are canceled or
postponed, we interviewed managers at various levels of the capital
budget preparation and review process.  We also judgmentally selected
and reviewed, in detail, 56 fiscal year 1994 budgeted projects for
the 6 activities we visited.  Based on this work, most cancellations
and postponements seem to be occurring because DOD has not corrected
the capital budgeting problems that existed before DBOF was created
in 1991.  In addition, Base Realignment and Closure decisions and
other budget uncertainties have created an environment that
contributed to capital projects being canceled and postponed. 


      WEAKNESSES IN THE BUDGET
      JUSTIFICATION PROCESS HAVE
      NOT BEEN CORRECTED
---------------------------------------------------------- Letter :4.1

DOD's industrial activities used revolving funds to finance capital
asset purchases between fiscal years 1983 and 1989 under what was
known as the Asset Capitalization Program.  In fiscal year 1990, the
Congress terminated this program and began funding capital equipment
purchases through the procurement appropriation.  This change, which
lasted 2 fiscal years, was aimed at giving the Congress greater
visibility over capital equipment purchases.  It was necessary
because of significant implementation problems service audit
agencies, inspector generals, and we repeatedly identified between
1986 and 1990. 

Before DBOF was implemented, we reported\3 that DOD had not made the
necessary changes to its capital equipment program.  At that time, we
concluded that the adoption of DOD's proposal to fund capital
equipment through DBOF, prior to correcting the previously reported
weaknesses, could continue the abuses and poor management practices
we found with the Asset Capitalization Program.  As described below,
many of the previously described weaknesses have continued under
DBOF. 


--------------------
\3 Industrial Funds:  Weaknesses Remain in the Department of
Defense's Capital Equipment Program (GAO/NSIAD-91-175, Apr.  17,
1991). 


         CAPITAL PURCHASES ARE NOT
         BASED ON LONG-RANGE
         STRATEGIC PLANS
-------------------------------------------------------- Letter :4.1.1

One of the major implementation problems with the Asset
Capitalization Program was that the industrial fund activities lacked
a systematic approach to identifying capital investment
opportunities.  Although each of the activities was required to
prepare long-range (3 to 7 years) strategic plans that identified
facility and equipment requirements, these plans were not being used
consistently to guide the activities' current equipment needs or to
buy priority equipment.  As a result, these activities had no
assurance that their most critical long-term needs were being met
through the Asset Capitalization Program. 

A similar situation existed at the six activities we visited. 
Although DOD relies on these activities to identify most of their
capital equipment needs, these needs were not linked in any
systematic way to the activities' long-range requirements and future
missions.  In fact, the activities were no longer preparing
long-range strategic plans.  Several managers told us they lacked the
resources to keep long-range plans current, and the downsizing
environment reduced the emphasis on long-range planning.  Officials
at the two Army activities we visited said that long-range plans are
no longer required. 

Instead, the activities generally relied on local managers to
identify and rank capital investment needs.  For example, the Naval
Air Warfare Center at Warminster, Pennsylvania, initially allows
department heads to identify capital projects.  These are reviewed
and prioritized by a management board, approved by the Warminster
Commanding Officer and other officials, and subsequently reviewed by
several additional layers in the Navy and the DOD Comptroller. 

However, (1) no documentation is prepared that links capital
investment projects to Warminster's long-term or future requirements,
(2) Warminster officials canceled or postponed a large number of
projects in the 1994 capital budget, and (3) higher level reviewers
within the Navy seldom question the projects selected by the field
activities.  They said the activities and their commands were in the
best position to know which projects best suited their requirements. 
This environment, in our view, does not provide the control necessary
to ensure that the projects selected are the ones that best match
long-range requirements. 


         CAPITAL PROJECTS ARE NOT
         ADEQUATELY JUSTIFIED,
         REVIEWED, AND APPROVED
-------------------------------------------------------- Letter :4.1.2

Another major implementation problem with the Asset Capitalization
Program was that the industrial fund activities were not complying
with procedures for justifying and approving capital projects.  By
not following these requirements, the activities had no assurance
that capital resources were being used on the best projects.  It also
did not give them a baseline to measure the financial benefits of the
projects. 

During our audit work, we found that not much had changed.  The Army
activities, for example, were not performing any project analysis or
preparing justifications until the year of execution.  That is,
justification documents for fiscal year 1993 projects were being
prepared in fiscal year 1993, not in fiscal year 1991 when the budget
was prepared.  As a result, the budget was little more than a listing
of projects local managers believed could be done within expected
budget allocations.  The Army Depot System Command also included a
$5.4-million "contingency" amount (for which there were no specific
projects) in the fiscal year 1994 capital budget sent to the
Congress. 

The consequence of this process is that when the Army activities
performed an analysis, usually prior to or as part of the procurement
action, they found many projects were not high priority.  For
example, one of Letterkenny's 1994 projects was for a machine that
punches holes in various metal components and precuts reinforcement
rods for concrete applications.  The existing machine was over 13
years old and beyond its estimated life expectancy.  For that reason,
a project to replace the machine was included in the budget, but when
an analysis later showed that the existing machine was in good shape,
the project was canceled.  At the time of our review, the Army was
aware of the deficiencies in its capital budget justification process
and was taking action to improve the process, starting with the
fiscal year 1994 capital budget. 

Although the problems were not as systemic at the Air Force and the
Navy activities we visited, none were fully adhering to sound
justification and approval criteria for capital investments.  A major
part of the problem is that DOD's current capital investment guidance
for DBOF activities does not adequately describe how to justify a
capital investment project.  More importantly, the services have not
yet developed detailed implementing policies and procedures for the
field activities to follow.  As a result, the activities were using
service-level and local guidance that was either severely deficient
or out of date.  The Air Force, for example, was using expired
guidance from the old Asset Capitalization Program.  This guidance
did not (1) reflect the major reorganization that had taken place at
the San Antonio Air Logistics Center, (2) assigned duties to
management positions that no longer existed, and (3) identified the
capital asset threshold as $5,000 rather than $15,000.  Also, the
Navy activities we visited were using expired guidance and
instructions from other Navy commands. 

This lack of policies and procedures was confirmed in a report issued
in July 1993 by the DBOF Implementation Review Group.  This group,
chartered by the Secretary of Defense, concluded that documentation
requirements for capital investment decisions are not clearly defined
and managers do not understand the process.  It recommended that the
DOD Comptroller clarify policy on techniques and procedures for
investment analysis.  This group also issued a DBOF improvement plan
in September 1993 that tasked the DOD Comptroller to develop guidance
on the techniques and procedures for analysis and documentation of
capital projects.  Implementation was anticipated for late 1994. 


         PROGRAM BENEFITS ARE NOT
         MEASURED
-------------------------------------------------------- Letter :4.1.3

An effective capital investment program contains a mechanism for
analyzing whether the projects meet the projected financial benefits
and for collecting data so that management can make better investment
decisions.  This mechanism, called a post-investment analysis, was
generally not done under the old Asset Capitalization Program.  As a
result, when we assessed this program in 1989, we concluded that DOD
did know what benefits the program had produced or if equipment
purchased had actually been used.  This was important because we
found many completed projects that had not achieved anticipated
results. 

Current DBOF criteria requires a post-investment analysis for any
capital project that was justified wholly or partially on the basis
of economic considerations.  During our visits, we did not look at
completed projects to determine whether they had achieved anticipated
results, but we did find that none of the activities were doing
post-investment analyses.  A San Antonio Air Logistics Center
official said, for example, that the Air Force Materiel Command no
longer required this type of analysis.  The Navy, on the other hand,
had specific criteria for performing a post-investment analysis. 
Unfortunately, activity managers at the Navy's Lakehurst and
Warminster facilities said that they do not do these type of
analyses.  A Warminster official cited resource constraints as the
primary reason for not performing a post-investment analysis. 


      UNCERTAIN ENVIRONMENT PLACES
      A HIGH PREMIUM ON CAPITAL
      INVESTMENT PLANNING
---------------------------------------------------------- Letter :4.2

All the activities we visited were affected by military downsizings,
base closure and realignment decisions, and other DOD management
initiatives.  Since 1991, for example, the Letterkenny Army Depot has
been either closed, downsized, realigned, or had its mission expanded
because of the Base Realignment and Closure process.  Likewise, the
Naval Air Warfare Center at Warminster, Pennsylvania, will move to
Patuxent River, Maryland, and become part of the Navy's Aircraft
Division as part of the 1991 Base Realignment and Closure
recommendations. 

Although the San Antonio Air Logistics Center was not directly
affected by closure and realignment decisions, all air logistics
centers and DOD depots are going through major changes that could
affect their missions.  In recent testimony, we discussed such issues
as depot closings, DOD efforts to arrive at a proper mix of depot
maintenance work between public and private sectors, and the
public-private competition initiative DOD is using to allocate the
depot maintenance workload.\4

According to agency officials, these initiatives plus other workload
shifts (e.g., B-52 maintenance is moving from San Antonio to the
Oklahoma City Depot) has made their capital asset needs hard to
predict.  Considering that the DBOF budget is prepared at the field
level almost 18 months before the fiscal year it will be executed in,
these officials said they were not surprised by the large number of
cancellations and postponements. 

However, in our review of the 56 projects, we were only able to tie 3
of the 36 cancellations and postponements specifically to the
uncertainty of the downsizing environment.  A number of projects were
canceled because of "other higher priority requirements." This was
particularly true at the San Antonio Air Logistics Center.  Because
this Center did not always keep documentation associated with the
cancellation decision, we were not able to determine if the
cancellations were linked to specific changes in the Center's
business environment. 

We understand the challenge DOD faces in trying to manage its capital
investment program during this period of uncertainty.  At the same
time, we believe adequately justifying capital investment projects
and linking them to the long-range strategic plans for each activity
is more important than ever.  Without the discipline associated with
such a sound investment planning process, funds can be wasted on
either unneeded or low priority projects. 


--------------------
\4 Depot Maintenance:  Issues in Allocating Workload Between the
Public and Private Sectors (GAO/T-NSIAD-94-161, Apr.  12, 1994). 


      BUDGET PRESENTATION DOES NOT
      ADEQUATELY REFLECT PROJECT
      CHANGES
---------------------------------------------------------- Letter :4.3

DOD's capital budget includes projects for 3 fiscal years:  the
current year under consideration and an update of the 2 prior years'
budgets.  For example, the fiscal year 1994 budget, which DOD
submitted to the Congress in April 1993, included capital projects
proposed for 1994 and an updated list of 1992 and 1993 projects. 

We found that it was difficult to track the changes that occurred
between the fiscal year 1993 budget and the 1993 update, primarily
for two reasons.  First, most capital projects (those under $500,000)
are summarized by DBOF business area and identified by single line
items in the budget.  Therefore, it is impossible for us or the
Congress to determine which or how many projects have been canceled
without comparing detailed backup information for the 2-year period. 
Second, DOD does not indicate in the budget update what projects over
$500,000 are replacements.  The only way to tell is to compare the
update with the previous year's budget, which is a labor-intensive
effort subject to error.  For example, we noted that three planned
fiscal year 1993 projects over $500,000 were not in the subsequent
budget update and assumed they had been canceled.  However, a service
official pointed out that they had not been canceled.  As a result of
new cost estimates of less than $500,000, these projects were no
longer identifiable as separate budget line items.  They were still
in the budget but as part of other budget categories. 


   DOD HAS DEVELOPED NEW CAPITAL
   ASSET JUSTIFICATION CRITERIA
------------------------------------------------------------ Letter :5

In response to the DBOF Implementation Review Group's September 1993
recommendations, DOD has developed new guidance for justifying and
performing economic analyses for DBOF capital investment projects. 
This guidance requires that all capital projects included in the DBOF
capital budget be supported by a sound analytical evaluation.  Based
on our review of the guidance, we believe that it has the
potential--if effectively implemented--to address most of the
problems we found with DOD's capital investment justification
process. 

The guidance requires DOD components to prepare a thorough economic
analysis for all DBOF projects over $100,000 at least 18 months
before the year of execution; certain environmental and equipment
replacement projects are exempt.  In addition, it requires activities
to prepare project documentation that, among other things, describes
the need for the project, workload projections that support the
requirement, feasible alternatives considered, total project costs
and savings expected over a 10-year period, estimating methods, and
intangible benefits. 

Similar requirements would apply to projects under $100,000, except
that the economic evaluation would be less than a complete economic
analysis.  We believe these changes will help solve the budget
justification deficiencies and require DBOF activities to include
only its highest priority projects in the capital budget. 

We do have three concerns about the new guidance.  First, it makes no
mention about the need to link capital projects to the long-range
investment needs of the DBOF activity.  DOD officials said, and to a
certain extent we agree, that the strict justification requirements
will reduce the likelihood that any unneeded project could be
supported.  They also pointed to new budget guidance that requires
capital assets to meet long-range planning and programming
objectives.  Nevertheless, any new capital investment policy would be
remiss if it did not require a direct link between large capital
investments and the long-range mission of the installation. 
Long-range planning is even more important in an environment of
downsizing since activities need to maximize shrinking resources. 

Second, the new guidance advocates investment decision criteria that
may not produce the greatest net benefits.  For projects less than
$100,000, for example, the draft guidance requires activities to use
"payback" (the time necessary for an alternative to repay its
investment cost) as the primary indicator to rank order projects. 
For projects equal to or over $100,000, the "benefit-to- investment
ratio" (total present value of benefits divided by total present
value of costs) is to be the primary indicator for ranking projects. 
This is contrary to the Office of Management and Budget (OMB)
criteria,\5 a recent GAO report,\6 and current economic literature
that advocates "net present value" as the appropriate criterion for
choosing among independent, competing investment projects.  "Net
present value" is the difference between the present value of
benefits and the present value of total costs.  It is favored over
other indicators because it more consistently results in the
selection of projects with the greatest benefits, net of cost.  (See
app.  I for numerical examples.) Furthermore, DOD would not need any
additional information, beyond that necessary to calculate payback
and benefit-to-investment ratios, to calculate net present value. 

Third, the new policy guidance will require a major adjustment in the
way activities select and justify capital projects--in effect a
cultural change.  We believe such a change will not come about just
by issuing a new policy statement, particularly for such
long-standing problems.  In February 1992, we reported that private
companies use a combination of techniques to successfully change
their cultures.\7 Two techniques most important to success were (1)
top management support and commitment to the effort and (2) training
of employees to instill in them the organization's new mission,
values, and guiding principles.  Other key techniques included
communicating the organization's vision and goals to its employees
and creating a specific management style that reinforces this desired
vision and these goals.  Unless DOD addresses these types of issues,
we do not believe the new policy will be any more successful than the
out-of-date and inadequate guidance that currently exists. 


--------------------
\5 U.S.  Office of Management and Budget, Circular No.  A-94 (revised
Oct.  29, 1992). 

\6 Federal Budget:  Choosing Public Investment Programs
(GAO/AIMD-93-25, July 1993). 

\7 Organization Culture:  Techniques Companies Use to Perpetuate or
Change Beliefs and Values (GAO/NSIAD-92- 105, Feb.  27, 1992). 


   DOD DID NOT IDENTIFY CAPITAL
   ASSET PROGRAM DEFICIENCIES AS A
   MATERIAL WEAKNESS
------------------------------------------------------------ Letter :6

Under the Federal Managers' Financial Integrity Act, the Secretary of
Defense is required to review DOD's internal accounting and
administrative controls to provide reasonable assurances that funds,
property, and other assets are safeguarded against waste, loss,
unauthorized use, or misappropriation and that internal management
controls emphasize prevention and correction of specific problems. 
DOD has not identified the capital asset program deficiencies we cite
in our report as material weaknesses requiring corrective action. 


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

We endorse the direction that DOD has taken to improve the capital
investment justification process.  To build on those planned actions,
we recommend that the Secretary of Defense

require that the new DBOF policy statement on capital budget
investment projects include requirements to (1) link capital
investment projects to the DBOF activities long-range plans and
missions and (2) rely on net present value as the primary investment
decision criterion for rank ordering competing capital investment
projects;

develop plans and schedules for training the key people responsible
for implementing the new guidance;

develop mechanisms to track implementation of the new guidance and
hold managers accountable for achieving the intent of the guidance;

include capital asset justification program deficiencies as a
material weakness in the Federal Managers' Financial Integrity Act
report; and

identify, in its annual DBOF capital budget update, (1) projects
canceled or postponed since submission of the last budget and (2)
projects selected as replacements for those canceled or postponed. 


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

DOD reviewed a draft of this report and provided written comments. 
In summary, DOD agreed that there was an overall need to improve its
policies governing the management of the DBOF capital asset program
and that it had recently made such changes, which it said were
consistent with improvements suggested in this report.  (See app. 
II.) It disagreed, however, with our recommendations to use net
present value as the primary investment decision criterion for
choosing among competing investment projects and to cite capital
asset justification deficiencies in the Federal Managers' Financial
Integrity Act report. 

DOD offers no specific reason it has not adopted net present value as
the primary criterion for choosing among competing investment
projects.  DOD's comments refer to its new DBOF policy statement that
it believes allows managers to consider net present value along with
other economic indicators.  While the policy statement does require
DBOF managers to calculate net present value for each investment
project, it says they should use either payback or
benefit-to-investment ratio as the primary criterion for ranking
projects.  As we discuss earlier, this is inconsistent with OMB
economic criteria and could cause managers to select projects that
will not produce the greatest net benefits.  (See app.  I.)

DOD also said that the capital asset program deficiencies we
identified are not sufficient to require inclusion under the Federal
Managers' Financial Integrity Act and that its new policy changes are
expected to achieve the desired improvements and internal controls. 
We disagree.  The problems with DOD's capital investment program are
long-standing and have been reported many times by us, the Inspectors
General, and service audit agencies over the past 6 years.  Although
the new policy statement is a step in the right direction, we believe
DOD needs high-level management oversight and attention to achieve
effective implementation.  Listing the program as a material weakness
in the Federal Managers' Financial Integrity Act report provides an
added level of management attention.  Further, during the fiscal year
1995 defense authorization process, the Senate and House Committees
on Armed Services considered the problems in this area serious enough
to reduce the money available for capital asset purchases by $160
million (from $1.6 billion spending authority requested by DOD to
$1.44 billion).  This emphasizes the need for DOD to address this
issue as a material weakness and ensure that improvements are
effectively implemented.  Additional DOD comments and our responses
appear in appendix II. 


---------------------------------------------------------- Letter :8.1

We performed our audit work between December 1992 and June 1994 in
accordance with generally accepted government auditing standards. 
(See app.  III for details on our scope and methodology.) We will
also be sending copies to the Chairmen, Senate Committee on
Governmental Affairs, House Committee on Government Operations, and
Senate and House Committees on Appropriations; the Director, Office
of Management and Budget; the Secretaries of Defense, the Army, the
Navy, and the Air Force; and other interested parties.  We will make
copies available to others on request. 

If you have any additional questions, please contact me on (202)
512-8412.  Major contributors to this report are listed in appendix
IV. 

Donna M.  Heivilin, Director
Defense Management and
 NASA Issues


BASIS FOR USING NET PRESENT VALUE
=========================================================== Appendix I

The new policy guidance states that the primary criterion used for
evaluating alternative investments should depend on the cost of the
project.  For projects under $100,000, the guidance requires the
minimum payback period; for those $100,000 or more, it requires the
maximum ratio of benefit to investment cost.  This appendix presents
some simple numerical examples to demonstrate that it is possible for
either of these two criteria to signal the selection of one or more
projects that differ from the selection signaled by the maximum net
present value criterion.\1

The minimum payback period criterion calls for selection of the
project that recovers its investment cost in the shortest period of
time.  Table I.1 shows a comparison of two competing, mutually
exclusive projects. 



                          Table I.1
           
              Comparison Based on Payback Period

                                   First year    Second year
                  Initial cost   net benefits   net benefits
Project                   (C0)       (B1 -C1)       (B2 -C2)
---------------  -------------  -------------  -------------
A                          100            110              1
B                          100              0           1000
------------------------------------------------------------
Both projects require an initial outlay of $100, the total budget
available for investment, and both last 2 years.  The cost of project
A is recouped during the first year, while cost recoupment for
project B does not occur until the second year.  According to the
minimum payback period criterion, therefore, A should be the project
chosen.  However, considering the size of the second year payoffs
($1,000) relative to those of the first year ($110), the minimum
payback period judgment is clearly faulty. 

The maximum benefit-to-cost ratio (B/C) criterion can signal the
wrong selection of projects.  Once again, consider two competing,
mutually exclusive projects, A and B, only one of which can, due to a
limited budget, be selected.  The life span of each project is 1
year.  Suppose that the interest rate appropriate for discounting
purposes is 5 percent. 
Table I.2 compares



                          Table I.2
           
             Comparison Based on Benefit-to-Cost
                            Ratio


Project         (B0)    (C0)    (B1)    (C1)     B/C   NPV\a
------------  ------  ------  ------  ------  ------  ------
A                  0       1       2       0     1.9     0.9
B                  0       5       8       0     1.5     2.6
------------------------------------------------------------
\a Net present value. 

According to the maximum benefit-to-cost ratio criterion, project A
should be chosen because its B/C, 1.9, exceeds that of project B,
1.5.  Yet a comparison of total benefits net of costs clearly
indicates that project B is preferable because project B's net
benefit, $2.60, exceeds that of project A, $0.90. 

Both of the preceding examples tacitly assume that only two projects
are candidates for selection.  Situations can arise, of course, when
two or more projects can be selected, subject to a budget constraint. 
In such a situation, ranking projects by their benefit-to-cost ratios
and choosing successively lower ranked projects (beginning with the
project having the largest benefit-to-cost ratio) will maximize total
net present value. 



(See figure in printed edition.)Appendix II

--------------------
\1 All of these examples are taken from Peter G.  Sassone and William
A.  Schaffer, Cost-Benefit Analysis:  A Handbook (New York:  Academic
Press, 1978), pp.  15 and 19-21. 


COMMENTS FROM THE DEPARTMENT OF
DEFENSE
=========================================================== Appendix I



(See figure in printed edition.)



(See figure in printed edition.)

 Now on pp.  3 and 4. 



(See figure in printed edition.)

 See comment 1. 



(See figure in printed edition.)

 Now on pp.  5 and 6. 

 See comment 2. 



(See figure in printed edition.)

 Now on p.  6. 

 See comment 3. 

 Now on p.  7. 



(See figure in printed edition.)

 See comment 4. 



(See figure in printed edition.)

 Now on pp.  7-9. 

 See comment 5. 

 See comment 6. 



(See figure in printed edition.)

 Now on p.  9. 

 See comment 7. 

 Now on pp.  9 and 10. 



(See figure in printed edition.)

 Now on pp.  10 and 11. 

 See comment 8. 



(See figure in printed edition.)

 Now on pp.  11-13. 

 See comment 4. 



(See figure in printed edition.)

 See comment 7. 

 See comment 6. 

 See comment 9. 

 See comments
on p.  14. 



(See figure in printed edition.)

 Now on p.  13. 

 See comments
on p.  14. 

 Now on p.  13. 

 See comment 4. 

 See comment 7. 



(See figure in printed edition.)

 See comment
on p.  14. 

 Now on p.  13. 

 See comment 9. 

 Now on p.  13. 

 See comment 10. 

 Now on p.  13. 

 See comments
on p.  14. 



(See figure in printed edition.)

 Now on p.  13. 

 See comment 8. 


The following are GAO's comments on the Department of Defense's (DOD)
letter dated September 16, 1994. 

GAO COMMENTS

1.  Here and several other times throughout the comments, DOD states
that the problems with the capital asset budgeting process have been
resolved.  As we state in the report, however, the Defense Business
Operations Fund (DBOF) entities we reviewed were not following
existing guidance and not much was being done at higher levels to
ensure that the capital asset justification criteria were being
followed.  Although the new guidance adds specificity to the
requirements for acquiring a capital asset, the key issue is
effective implementation.  That is why we included recommendations
for DOD to train its key managers on how to implement the new
guidance, develop performance measures to track implementation, hold
managers accountable for achieving the intent of the guidance, and
include capital equipment program deficiencies in its Federal
Managers' Financial Integrity Act report. 

2.  We found no evidence that capital asset projects were being
systematically assessed against this type of criteria.  To the
contrary, we saw a rather loose capital asset justification process
that did not match the criteria to which DOD refers.  DOD's DBOF
Implementation Review Group found similar circumstances and
recommended that the DOD Comptroller develop guidance for analyzing
and documenting its capital investment decisions. 

3.  DOD's comment is out of context.  At this point in the report, we
are describing the results of our work as it relates to findings in
past reports by us, defense Inspectors General, and service audit
agencies.  In that context, we found that DOD had not corrected
previously identified problems.  We recognize later in the report
that DOD has developed new policy guidance that if properly
implemented, will help resolve the problems we identified during our
work. 

4.  DOD states that the necessary controls are in place to ensure
selected capital projects match long-range plans of the DBOF
activity.  As support, it refers to new budget guidance that was
issued in May 1994 and the new economic analysis policy for capital
projects.  During our work, however, we found a more basic problem. 
As we report, the activities we visited were not preparing long-range
plans either because they lacked the resources to do so, or thought
the requirement had been eliminated.  Regardless of the reason, they
were not attempting to match large capital purchase needs to the
long-term future of that activity.  In addition, we found little
evidence that any of the review levels in the services or the Office
of the Secretary of Defense (OSD) were performing this function;
local managers were being relied upon to identify the projects they
thought most appropriate for the budget. 

More importantly, criteria already exists that requires long-range
plans and the matching of capital asset projects to those needs. 
While we are recommending that the new policy include requirements to
match capital asset needs to long-range plans, we also recognize that
the policy is not enough.  As stated in the report, DOD must also
address long-standing cultural issues and develop ways to ensure that
the policies are effectively implemented. 

5.  DOD was developing its new policies for acquiring capital
investments as we completed our work and did not finalize them until
after it had received our report for comment.  Consequently, we have
adjusted our report to recognize that the new policies have been
completed. 

6.  We are aware that the military services and other defense
components were involved in developing the new policy but do not
believe that is enough to ensure effective implementation.  The
problems we describe in this report are long-standing deficiencies
that will likely require direct intervention and continued management
oversight and attention to correct.  Our recommendations were
developed with these long-term requirements in mind. 

7.  When we prepared our draft report, the DBOF Policy Committee
charged with developing DOD's new capital investment policy had
agreed to eliminate the requirement to perform post-investment
analyses for capital assets.  The majority position of this committee
was that limited resources should not be used to measure, track, and
evaluate sunk investment costs.  The DOD comptroller added the
requirement to perform post-investment analyses when he approved the
statement on August 8, 1994.  Unless DOD develops a tracking and
accountability system, as we recommend, compliance with this
post-investment policy may not be any better than it was with the
last one. 

8.  DOD agrees with our recommendation to update the DBOF capital
budget by identifying projects canceled or deferred since the last
budget and those that have taken their place.  It proposes to do
this, however, for only those projects over $500,000 that are shown
as separate line items in the budget.  This, in our view, is not
enough to keep the Congress fully informed of DOD's progress in
bringing stability to the capital budgeting process.  As we show in
this report, the DBOF activities we visited canceled or postponed 86
percent and 65 percent of their budgeted projects during fiscal years
1993 and 1994, respectively.  Because only 3.3 percent (15 of 456) of
these canceled or deferred projects were under $500,000, DOD's
proposal to report only on those over $500,000 will do little to keep
the Congress informed.  An alternative we discussed with DOD
comptroller officials was to report on a project-by-project basis for
projects over $500,000 and to report in a summary manner on those
projects under $500,000.  This will give the Congress information
similar to that in this report and serve as an effective measure of
DOD's progress in implementing its new DBOF capital investment
policy. 

9.  DOD agrees with our recommendation for training the key people
responsible for implementing the new guidance.  As a solution,
however, it is planning to incorporate economic analysis modules into
existing training courses that are generally made available to its
workforce.  Comptroller representatives estimated that it could take
2, 3, or more years to cycle its key budget analysts, comptrollers,
and management analysts through these courses.  Although this is
certainly an important component of training that is past due, we do
not believe it will address the more immediate need to ensure that
managers responsible for developing the DBOF capital budget
understand and implement the new policy and budget guidance. 

10.  DOD does not identify any mechanisms or performance measures it
will develop to track implementation of the new guidance.  Without
this type of information, it will be difficult to know how well the
new policy is being implemented or to identify the managers who are
not adequately adhering to the new requirements. 


SCOPE AND METHODOLOGY
========================================================= Appendix III

We performed our audit work at the DOD Comptroller's Office, military
services, and defense agency headquarters as well as the three
command and six field activity locations listed in table III.1. 



                         Table III.1
           
                  DOD Organizations Visited

Service        Business area  Command and field activity
-------------  -------------  ------------------------------
Army           Depot          Depot System Command
               maintenance    --Letterkenny Army Depot
                              --Tobyhanna Army Depot

Navy           Research and   Naval Air Systems Command
               development    --Naval Air Warfare
                              Center, Warminster
                              --Naval Air Warfare
                              Center, Lakehurst

Air Force      Depot          Air Force Materiel Command
               maintenance    --San Antonio Air
                              Logistics Center

Air Force      Supply         Air Force Materiel Command
               management     --San Antonio Air
                              Logistics Center
------------------------------------------------------------
We selected these locations to cover a cross-section of DBOF business
areas and expected volume of capital investment projects.  We
interviewed responsible agency personnel and obtained pertinent
documentation as it related to the DBOF process for capital project
budget preparation and review. 

To determine the extent to which DOD carries out the DBOF Capital
Budget it sends to the Congress, we (1) identified the universe of
capital projects included in the fiscal years 1993 and 1994 capital
budget for the activities we visited and (2) compared them to the
projects actually undertaken during those 2 fiscal years. 

To assess the effectiveness of the budget preparation and review
process and determine if capital projects are adequately justified
and economically supported, we (1) reviewed the DOD policies,
procedures, and guidance used to prepare and review capital budget
projects and (2) identified internal controls in place to ensure that
capital projects are selected in accordance with the procedures and
guidance. 

We judgmentally sampled 56 of 140 capital projects included in the
various fiscal year 1994 budget submissions for the activities we
visited.  In selecting projects, we placed more emphasis on capital
projects over $500,000.  For all 56 projects, we (1) determined
whether there was adequate documentation justifying the project,
including, where appropriate, a properly prepared economic analysis
and (2) examined, when applicable, the reasons for project
cancellations and postponements. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IV

NATIONAL SECURITY AND
INTERNATIONAL AFFAIRS DIVISION,
WASHINGTON, D.C. 

David R.  Warren
James E.  Hatcher
Edward J.  Rotz
Joseph A.  Margallis
Audrey M.  Petit
George C.  Surosky
Melissa Niedosik
Calvin E.  Phillips
Donald R.  McCuistion

OFFICE OF CHIEF ECONOMIST

Harold J.  Brumm
