Defense Restructuring Costs: Projected and Actual Savings from Martin
Marietta Acquisition of GE Aerospace (Letter Report, 09/05/96,
GAO/NSIAD-96-191).
Pursuant to a legislative requirement, GAO reviewed the restructuring
costs for 17 Department of Defense (DOD) projects, focusing on whether:
(1) the DOD certification process complies with DOD regulations; (2)
projected savings are in line with original estimates; and (3) project
restructuring has resulted in lower DOD contract prices.
GAO found that: (1) the five restructuring projects reviewed comply with
DOD regulations; (2) one DOD contractor has submitted restructuring
proposals that indicate a net reduction of projected overhead costs for
applicable business segments; (3) there is a savings of $1.50 to $7.00
for every dollar DOD invests in contractor restructuring costs; (4)
certified savings for the five projects reviewed represent 88 percent of
the contractor's original estimate and savings for the last three
projects represent 10 percent of the original estimate; (5) these
savings are lower than initially estimated because the contractor
reduced its projection savings in the restructuring proposals; (6)
projected overhead costs are lower in those business segments where the
five projects are being executed; (7) the contractor has reduced DOD
projected overhead costs by $2.01; and (8) this reduction has resulted
in lower overhead rates for certain business segments and procurement
activities.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: NSIAD-96-191
TITLE: Defense Restructuring Costs: Projected and Actual Savings
from Martin Marietta Acquisition of GE Aerospace
DATE: 09/05/96
SUBJECT: Department of Defense contractors
Defense cost control
Overhead costs
Defense contracts
Defense procurement
Contract administration
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Cover
================================================================ COVER
Report to Congressional Committees
September 1996
DEFENSE RESTRUCTURING COSTS -
PROJECTED AND ACTUAL SAVINGS FROM
MARTIN-MARIETTA ACQUISITION OF GE
AEROSPACE
GAO/NSIAD-96-191
Defense Restructuring Costs
(705127)
Abbreviations
=============================================================== ABBREV
DCAA - Defense Contract Audit Agency
DCMC - Defense Contract Management Command
DOD - Department of Defense
Letter
=============================================================== LETTER
B-272422
September 5, 1996
The Honorable Strom Thurmond
Chairman
The Honorable Sam Nunn
Ranking Minority Member
Committee on Armed Services
United States Senate
The Honorable Floyd Spence
Chairman
The Honorable Ronald V. Dellums
Ranking Minority Member
Committee on National Security
House of Representatives
Section 818 of the National Defense Authorization Act for Fiscal Year
1995 (P.L. 103-337) restricts Department of Defense (DOD) payments
of restructuring costs\1 associated with defense contractor business
combinations. Specifically, it prohibits the payment of
restructuring costs until a senior DOD official certifies in writing
that projected savings from the restructuring are based on audited
data and should result in overall reduced costs to DOD. In response
to section 818, DOD issued interim regulations, effective December
29, 1994, on the allowability of restructuring costs.\2
The act also calls for our office to periodically report on the
implementation of these DOD regulations. We have already issued two
reports on the subject.\3 This report discusses the 17 restructuring
projects proposed for payment by Martin Marietta Corporation,\4 as a
result of its acquisition of General Electric Company's aerospace
business segments.\5 DOD has certified 8 of the 17 projects. We
reviewed in detail the first five projects certified, and our review
indicated the other three projects are similar. The objectives of
our review were to determine whether (1) the certification process
for the five projects was carried out in accordance with the
regulations, (2) the savings were in line with the original
estimates, and (3) the restructuring resulted in lower DOD contract
prices.
To avoid the disclosure of proprietary data, we do not discuss
specific dollar amounts applicable to Martin Marietta Corporation's
restructuring.
--------------------
\1 Restructuring costs cover a wide range of expenses, such as
personnel relocations, severance pay, early retirement incentives,
equipment relocations, plant rearrangements, and facility closings.
\2 DOD published the final regulation on restructuring costs in the
Federal Register dated April 18, 1996. Differences between the
interim and final regulations have no bearing on the matters
discussed in this report.
\3 Defense Restructuring Costs: Payment Regulations Are Inconsistent
With Legislation (GAO/NSIAD-95-106, Aug. 10, 1995) and Defense
Contractor Restructuring: First Application of Cost and Savings
Regulations (GAO/NSIAD-96-80, Apr. 10, 1996).
\4 Martin Marietta Corporation and Lockheed Corporation merged
operations on March 15, 1995, to form the Lockheed Martin
Corporation. We are using the former name--Martin Marietta
Corporation--in the report because the merger with Lockheed
Corporation had not taken place at the time the General Electric
business segments were acquired.
\5 The acquisition also included General Electric's government
services operations.
RESULTS IN BRIEF
------------------------------------------------------------ Letter :1
Our review indicated DOD's actions to review and certify the first
five projects complied with the restructuring regulations. As
required by those regulations, the contractor submitted restructuring
proposals for the projects, which were then audited; a senior DOD
official certified that the audited projects should result in overall
reduced costs to DOD; and finally, advance agreements\6 were executed
on the projects.
Documented savings from business combinations have not always been as
great as initially expected. In the case of Martin Marietta
Corporation's acquisition of the General Electric business units,
estimated restructuring savings for the eight certified projects are
less than half of the contractor's initial rough-order-of-magnitude
estimates. This difference exists primarily because the contractor
lowered its estimated savings at the time it prepared detailed
restructuring proposals and DOD negotiated reductions in the proposed
savings during the certification process.
Although certified savings are less than initially estimated, the
contractor's overhead costs are lower as a result of savings from
these projects. Consequently, the government official responsible
for negotiating overhead costs and rates provided procuring
activities with lower overhead rates for use in pricing DOD
contracts.
--------------------
\6 The advance agreements contain pertinent information about
restructuring projects, including a description of the projects,
estimated restructuring savings and costs, and the way that
restructuring costs will be charged to contracts.
BACKGROUND
------------------------------------------------------------ Letter :2
The Defense Contract Management Command (DCMC) has lead
responsibility for implementing DOD's restructuring regulations and
is currently tracking 32 defense contractor business combinations.
For three of these combinations,\7 the Under Secretary of Defense
(Acquisition & Technology) has certified an estimated net DOD savings
of $390.4 million. The Defense Contract Audit Agency (DCAA) has
completed audits of restructuring proposals for three additional
business combinations and is reviewing proposals submitted for four
other combinations.
Martin Marietta Corporation entered into formal discussions with
General Electric Company on October 30, 1992, to acquire its
aerospace and certain other business operations. The acquisition was
effective April 2, 1993, and combined two of the nation's leading
aerospace research and development organizations. After the
acquisition, Martin Marietta Corporation began restructuring the new
organization by establishing
17 projects, which ranged from consolidating corporate headquarters
in Bethesda, Maryland, to relocating and consolidating selected
operations at its facilities in Orlando, Florida.
Of the original 17 projects, DOD eliminated 3 from consideration
under section 818 because they involved normal internal downsizing
efforts, unrelated to the business combination, or were not
applicable to defense work. The Under Secretary of Defense
(Acquisition and Technology) issued a certification of net benefit
for five projects on September 19, 1995, and for three additional
projects on February 14, 1996. At the time we completed our review,
six projects remained to be certified.
--------------------
\7 The three business combinations are United Defense, Martin
Marietta Corporation-General Electric Aerospace (8 of 14 projects),
and Northrop- Grumman.
DOD ACTIONS COMPLIED WITH
INTERIM REGULATIONS
------------------------------------------------------------ Letter :3
Martin Marietta Corporation started its restructuring before the
interim regulations were issued; nonetheless, DOD's actions to review
and certify the five restructuring projects complied with the
regulations. The regulations direct the administrative contracting
officer, for example, to require the contractor to submit a
restructuring proposal, request an audit of the proposal, and
negotiate an advance agreement between the government and contractor.
The regulations also require a senior-level DOD official to issue a
certification of net benefit for the restructuring.
For the five projects we reviewed, Martin Marietta Corporation
submitted proposals showing restructuring savings would result in a
net reduction of projected overhead costs\8 for the applicable
business segments. DCAA reviewed the proposals and issued audit
reports in March 1995. Through negotiations with the contractor, the
administrative contracting officer obtained agreement on most of the
restructuring costs and savings DCAA questioned and recommended the
net benefits be certified. On September 19, 1995, the Under
Secretary of Defense (Acquisition and Technology) certified the net
benefit for the five projects. After certification, the
administrative contracting officer executed advance agreements for
the projects containing the negotiated restructuring costs and
savings, cost ceilings, and other pertinent information.
--------------------
\8 Costs such as facilities and equipment, general office support,
and supervisors' salaries are typically classified as overhead costs,
or indirect costs, because they are not directly assignable to a
specific contract but benefit more than one contract.
SAVINGS WERE LESS THAN
ORIGINALLY PROJECTED
------------------------------------------------------------ Letter :4
As part of the public announcements of new business combinations,
defense contractors generally provide a rough-order-of-magnitude
estimate of restructuring savings. Such estimates were discussed in
congressional hearings leading up to enactment of section 818. The
Deputy Secretary of Defense, for example, testified before a
congressional subcommittee in mid-1994 that early estimates from four
recently announced business combinations indicated that projected
savings ranged from one and a half to seven times the projected cost.
Later in those hearings, however, the Deputy Secretary told the
subcommittee that savings on future business combinations could range
from four to seven times the projected costs. In other words, for
every dollar DOD invests in restructuring costs, it could realize
savings of $1.50 to $7.00. Savings achieved on the two business
combinations we reviewed fall on the low side of the Deputy
Secretary's projection.
Restructuring savings resulting from Martin Marietta Corporation's
eight certified projects are less than its initial rough-order-of-
magnitude estimates. In its initial restructuring projection for the
eight projects, Martin Marietta estimated that $1.00 in restructuring
costs would reduce overhead costs by $2.73 for the first five
projects and $76.84 for the last three projects. These projected
reductions in overhead included both the contractor's and DOD's
share.
After the projects were certified, $1.00 in restructuring costs was
projected to reduce overhead costs by $2.41 for the first five
projects and $8.02 for the last three projects. These reductions
also included both the contractor's and DOD's share. Certified
savings for the first five projects were therefore about 88 percent
of the contractor's original estimates, but certified savings for the
last three projects were only about 10 percent of the original
estimates.
When considering all eight projects together, $1.00 in restructuring
costs was originally projected to reduce overhead costs by $5.24.
After certification, $1.00 in restructuring costs was projected to
reduce overhead costs by $2.57, which represents only about 49
percent of the contractor's original projection.
Projected savings are lower than initially estimated because the
contractor reduced its projection of savings when it prepared
detailed restructuring proposals for the projects. Also, DOD
negotiated reductions in the contractor's proposed restructuring
savings during the certification process. For example, the
government negotiator did not categorize the elimination of General
Electric's corporate overhead costs as restructuring savings in the
project where the contractor proposed to do this because the
elimination resulted from the business combination itself and not
from actions taken after the combination. The contractor agreed to
the negotiator's categorization on a nonprecedence-setting basis in
order to proceed with the certification process.
This project comprised $2.42, or about 46 percent, of the $5.24
reduction in overhead costs the contractor initially projected for
the eight projects, but it comprised only $0.04, or about 2 percent,
of the $2.57 certified reduction in overhead costs. While most of
the proposed savings from this project were not accepted by the
government as restructuring savings, the contractor contended the
government would still realize savings from the elimination of
General Electric's corporate overhead.\9
The history of the first eight projects certified, coupled with the
fact that the United Defense restructuring\10 achieved savings of
less than 15 percent of the original estimate,\11 shows that
certified savings have been considerably less than initially
estimated. These results are consistent with the Federal Trade
Commission staff's conclusion that mergers do not consistently
produce the predicted efficiencies. The Commission's staff reached
this conclusion after examining the empirical literature on the
results of mergers in general.\12
--------------------
\9 The amount of government savings from eliminating General Electric
corporate overhead would depend on a number of factors, including the
number of contracts transferred to Martin Marietta that were fixed
price versus cost, length of the remaining performance periods of the
contracts, and the amount of government sales at the business
segments where the contracts were transferred. The contractor agreed
these factors would reduce the amount of savings the government would
realize. Neither we nor DCAA estimated the impact of these factors
because the savings were not categorized as restructuring savings.
\10 We reported on the United Defense business combination, the first
to be officially certified for payment, in Defense Contractor
Restructuring: First Application of Cost and Savings Regulations
(GAO/NSIAD-96-80, Apr. 10, 1996).
\11 Several factors accounted for the difference between the original
and certified estimate of restructuring savings in the United Defense
business combination, including the use of different cost elements
for estimating purposes, different time periods for savings, and a
rough- order-of magnitude estimate versus a detailed cost proposal.
\12 Anticipating the 21st Century: Competition Policy in the New
High- Tech, Global Marketplace, Federal Trade Commission Staff, May
1996.
RESTRUCTURING CONTRIBUTED TO
LOWER CONTRACT PRICES
------------------------------------------------------------ Letter :5
Although restructuring savings are less than initially estimated, the
contractor's projected overhead costs are lower at the business
segments where the five restructuring projects are being executed.
For every dollar in restructuring costs for these projects, the
contractor reduced DOD's share of projected overhead costs by
$2.01.\13 The reduction in projected overhead costs is reflected in
lower overhead rates for these business segments, and the lower
overhead rates have been provided to procuring activities for use in
pricing DOD contracts. When the procuring activities use the lower
rates, DOD's contract prices will be lower than they would have been
had it not been for the restructuring under these five projects.
--------------------
\13 DOD's share of restructuring savings will vary between the
project and business segment based on the total dollar value of DOD's
contracts in relation to the total dollar value of all other
contracts, including commercial and direct foreign sales.
AGENCY COMMENTS
------------------------------------------------------------ Letter :6
In commenting on a draft of this report, DOD concurred with the
report. DOD suggested several clarifications in the report, and we
have incorporated them in the text where appropriate. DOD's comments
are presented in their entirety in appendix I.
SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7
We made a detailed examination of the first five certified
restructuring projects because they were the only projects certified
when we began our review. Also, these five projects are
representative of the other three projects that were certified after
we initiated our work. In addition, the other three projects were
subjected to the same certification process as the five projects we
reviewed in detail, and DOD's actions complied with the same four
major elements of the process.
To determine whether the process for the first five projects
certified was carried out in accordance with DOD's interim
regulations, we used a twofold approach. For those actions taken
before the regulations were issued, we determined whether the actions
met the intent of the regulations. For actions that had not taken
place, we compared the execution of the actions with the specific
requirements of the regulations. In doing this work, we examined the
restructuring proposals, audit reports, negotiation memorandums,
advance agreements, correspondence, the net benefit certification,
and other related documents and records.
To determine whether the projects resulted in lower DOD contract
prices, we traced the savings in the contractor's overhead cost
proposals and determined that proposed overhead costs were lower than
they would have been had the restructuring not occurred. We also
determined that the recommended overhead pricing rates were based on
the lower overhead costs and that the lower rates were provided to
procuring activities for use in pricing DOD contracts. In making
these determinations, we examined the contractor's overhead costs
proposals, the results of DCAA's audits of the proposals, the
recommended overhead pricing rates, and other related documents and
reports.
We discussed various aspects of the restructuring activities with
officials from Martin Marietta Corporation, the Office of the
Director of Defense Procurement, DCMC, and DCAA. We performed our
review between December 1995 and June 1996 in accordance with
generally accepted government auditing standards.
---------------------------------------------------------- Letter :7.1
We are sending copies of this report to the Chairmen of the Senate
Committee on Government Affairs, the House Committee on Government
Reform and Oversight, and the Senate and House Appropriations and
Budget Committees; the Secretaries of Defense, the Army, the Air
Force, and the Navy; the Commander, DCMC; the Director, DCAA; and the
Chief Executive Officer, Lockheed Martin Corporation. We will
provide copies 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, and Stacey E. Keisling.
David E. Cooper
Associate Director
Defense Acquisitions Issues
(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================== Letter
(See figure in printed edition.)
*** End of document. ***