Navy Inventory Management: Improvements Needed to Prevent Excess
Purchases (Letter Report, 04/30/1998, GAO/NSIAD-98-86).

This is one in a series of GAO reports on the military's management of
secondary inventory--spare and repair parts and other items that support
the Defense Department's (DOD) operating forces on land, at sea, and in
the air. During the past several years, GAO has repeatedly cited the
management of defense inventory as a high-risk area. This report focuses
on excess inventory that the Navy had on order. GAO discusses whether
the Navy (1) had valid requirements to support inventory purchases, (2)
had purchased items that exceeded needs and the causes of this
condition, and (3) was canceling purchases that exceeded needs.

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

 REPORTNUM:  NSIAD-98-86
     TITLE:  Navy Inventory Management: Improvements Needed to Prevent
	     Excess Purchases
      DATE:  04/30/1998
   SUBJECT:  Inventory control systems
	     Military inventories
	     Spare parts
	     Contract termination
	     Military cost control
	     Internal controls
	     Surplus federal property
	     Logistics
	     Property and supply management
	     Naval procurement

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

Report to Congressional Requesters

April 1998

NAVY INVENTORY MANAGEMENT -
IMPROVEMENTS NEEDED TO PREVENT
EXCESS PURCHASES

GAO/NSIAD-98-86

Navy Inventory Management

(709249)

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

  DOD - Department of Defense

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

B-276827

April 30, 1998

The Honorable J.  Dennis Hastert
Chairman
The Honorable Thomas M.  Barrett
Ranking Minority Member
Subcommittee on National Security,
 International Affairs, and Criminal Justice
Committee on Government Reform and Oversight
House of Representatives

This report is one in a series of reports on the Department of
Defense's (DOD) management of secondary inventory--spare and repair
parts and other items that support DOD's operating forces on land, at
sea, and in the air.\1 Over the past several years, we have issued a
number of testimonies and reports that cite the management of defense
inventory as a high-risk area.\2

As requested, we focused this review on excess inventory the Navy had
on order.  Specifically, this report addresses whether the Navy (1)
had valid requirements to support inventory purchases, (2) had
purchased items that exceeded needs and the causes of this condition,
and (3) was canceling purchases that exceeded needs.

--------------------
\1 See Related GAO Products at the end of this report.

\2 In 1990, we began a special effort to review and report on the
federal program areas designated as high risk because of their
vulnerabilities to waste, fraud, and abuse.  This effort, which was
supported by the Senate Committee on Governmental Affairs and the
House Committee on Government Reform and Oversight, focused on
problems that were costing the government billions of dollars.  We
identified DOD's secondary inventory management as a high-risk area
at that time because of the high levels of inventory in excess of
current needs and the lack of adequate systems for determining
inventory requirements.

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

Inventory management comprises several major functions, including
determining what is needed; buying needed items; and storing,
maintaining, distributing, and disposing of these items once they are
received.  Inventory control points, along with other activities such
as maintenance depots and disposal activities, perform these
inventory management functions.

This report focuses on the Navy's processes for determining inventory
requirements and making related purchases.  These functions are
primarily the responsibility of the Naval Inventory Control Point,
which has offices in Philadelphia and Mechanicsburg, Pennsylvania.
These functions are important because the Navy annually purchases
$3.1 billion of inventory and has an on-hand inventory valued at
$16.8 billion.

The Navy uses an automated process called Supply Demand Review as the
primary means to assist item managers in determining how much
inventory needs to be purchased and when and if contracts need to be
awarded, canceled, or modified.  The process uses inventory data and
mathematical models to determine inventory needs and to compare the
needs to on-hand and due-in inventory.  Due-in inventory represents
items on purchase requests,\3 items that have been ordered but not
received, and items the Navy already owns but are in transit between
activities.

Inventory requirements considered during the process include one or
more of the following:

  -- Reorder level requirement.  This requirement is for stock needed
     during the time it takes to purchase or repair an item plus a
     safety level of stock in case of unexpected increases in demand
     or the time needed to purchase or repair an item.

  -- Planned program requirement.  This requirement is for (1) pools
     of parts that permit the timely completion of repairs scheduled
     at maintenance depots or the unscheduled replacement of failed
     parts and (2) parts for future needs such as ship or aircraft
     modifications that have specific dates on which the parts are
     needed.

  -- Due out requirement.  This requirement is used to satisfy
     requisitions for stock that is on hand and not yet sent to the
     customers.

  -- Backorder requirement.  This requirement is used to satisfy
     requisitions that have been received but cannot be satisfied
     from stock on hand.

  -- War reserve requirement.  This requirement is used to ensure
     fast mobilization in the event of war.

When an item manager determines that more items are needed than are
on hand and due in, a contract is generated for the quantity that is
needed plus an economic order quantity--the amount of inventory that
will result in the lowest total costs for ordering and holding
inventory.  A contract can be terminated or modified if requirements
change.

Our analysis of September 30, 1996, computerized Navy inventory files
showed that the Navy was purchasing a reported $1.6 billion of
secondary inventory, $121 million of which exceeded requirements and
economic order quantities.  We judgmentally selected 200 items with a
reported $48.3 million of inventory on contract that were not needed
as of September 30, 1996.  We reviewed these items to determine if
the Navy had valid requirements to support inventory purchases, what
caused purchases to exceed requirements, and what the Navy was doing
to cancel purchases that were beyond what was needed.  Although this
report concentrates on the processes for determining inventory needs
and canceling excess purchases, past reports have discussed problems
with the visibility and accuracy of on-hand and in-transit
inventories.  The scope and methodology of our work are described in
appendix I.

--------------------
\3 Item managers issue an internal document called a purchase request
when they determine that inventory needs to be purchased.  Inventory
is considered to be on a purchase request until a contract is
awarded.

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

We identified several problems that affect the decision-making
process for billions of dollars of inventory.  However, we cannot
precisely quantify the overall extent of the problems.  Specifically,
our work shows that in some cases purchases (1) were not based on
valid needs, (2) were excess to needs because the requirements
changed after orders were placed, and (3) occurred even though
contracts could have been canceled.

  -- The Navy did not always have valid requirements to support
     inventory purchases.  For example, 68 of the 200 items reviewed
     had about $13 million of planned program requirements that could
     be eliminated because the requirements were also included in the
     reorder level requirement.  This double counting could be
     indicative of a larger problem because the Navy has a total of
     about $3.3 billion in planned program requirements that affect
     purchase decisions.\4 We previously recommended that DOD revise
     policies and procedures to eliminate this duplication of
     requirements.  While DOD has acted on many of our past
     recommendations, it has not taken corrective action on this one.
     We also identified other instances where inventory was purchased
     without an adequate basis.

  -- Several factors contributed to the excess inventory on contract.
     Recurring demands for certain items had decreased, engineering
     estimates for requirements had not materialized, nonrecurring
     demands were delayed or were not needed, and parts had become
     obsolete.  Although some of these factors could not have been
     anticipated, in other cases better management could have
     eliminated or minimized the accumulation of inventory that
     exceeded needs.  The Navy did not know if planned program
     requirements accurately reflected needs.  Also, broken parts to
     be returned for repair were not adequately considered when
     making purchase decisions.

  -- The Navy canceled some contracts for excess inventory but could
     have canceled more.  A major reason for not canceling more
     purchases was that the Navy adds "protection levels,"
     representing as much as 2 years of usage, to requirements before
     considering cancellation and cancels only the amount of the
     purchases that exceeds the protection levels.  The 2-year usage
     represented nearly four times the amount of inventory that the
     Navy would normally buy.  The Navy missed additional
     opportunities to cancel purchases because item managers did not
     exercise their responsibility to direct the cancellation of
     contracts, economic analyses were not made, and inventory and
     contracting records did not agree.

Collectively, these problems contribute to the Navy having inventory
in excess of needs.

--------------------
\4 The dollar value of a requirement error has something less than a
one-to-one relationship to the amount of an item purchased.  This is
because requirements data are used to identify the aggregate amount
of inventory needed over a period of time and not the most economic
amount that should be purchased at any one point in time.

   INVENTORY PURCHASES WERE NOT
   ALWAYS SUPPORTED BY VALID NEEDS
------------------------------------------------------------ Letter :3

Our analysis of 200 judgmentally selected items showed that the Navy
duplicates some inventory requirements, resulting in unnecessary
purchases and inventory that exceeds needs.  Also, inventory was
purchased without specific requirements or on the basis of inaccurate
demand forecasts.

      SOME REQUIREMENTS WERE
      COUNTED TWICE
---------------------------------------------------------- Letter :3.1

One of the Navy's uses of planned program requirements is to provide
pools of parts that permit the timely completion of repairs scheduled
at maintenance depots or the unscheduled replacement of failed parts.
In these situations, the demand generated by the replacement of these
parts as they are issued is used to compute reorder levels.  The
Navy, however, continues to add planned program requirements to these
reorder level requirements in determining total requirements.  Thus,
planned program requirements are counted twice.

Of the 200 items reviewed, 88 items had $38.4 million of planned
program requirements that generated demands used to compute reorder
levels.  We estimate that about $13 million for planned program
requirements could be eliminated because recurring demands resulting
from these requirements were already included in the calculation of
amounts to order.\5 This practice could be of greater significance
because the Navy has about $3.3 billion of planned program
requirements that generate demands used to compute reorder levels.
Consequently, some part of these requirements could be eliminated,
thus ultimately reducing actual purchases.  The following examples
show the effect of the double counting:

  -- In May 1997, Navy supply records showed that the Navy needed to
     buy two manifold assemblies, used on FFG class guided missile
     frigates, each costing $27,895.  Requirements included a reorder
     level of nine assemblies and a planned program requirement for
     three assemblies.  Demands used to compute the reorder level
     requirement included those to replenish the planned program
     requirement.  As a result, the requirement was counted
     twice--once as part of the reorder level and again as part of
     the planned program requirements.  By removing the planned
     program requirements, which represented about 3 years of supply,
     the need for the buy could have been eliminated and requirements
     could have been reduced by three assemblies, costing a total of
     $83,685.

  -- In November 1997, the Navy projected a buy for 29 rotary wing
     blades used on the AH-1W attack helicopter.  Requirements
     included a reorder level requirement of 49 blades and a planned
     program requirement for 6 blades.  Demands used to compute the
     reorder level included those to replenish the planned program
     requirements.  As a result, the requirement was counted
     twice--once as part of the reorder level and again as part of
     the planned program requirements.  Eliminating the planned
     program requirements could have reduced the projected buy by six
     blades, or about $412,500.  The six blades represent about 6
     months of supply.

The Navy took action to eliminate or lessen duplicate requirements in
one case.  For a self-locking nut used on the engine for the UH-1N
utility helicopter, the Navy reduced inventory requirements by 3,456
nuts costing about $1,700.  A February 1996 purchase of 17,120
self-locking nuts was justified by a reorder level of 14,155 nuts and
planned program requirements for an additional 4,201 nuts.  The Navy
subsequently decreased the planned program requirements to 292 nuts.
Inventory control point officials stated that the largest part of the
decrease was due to deleting planned program requirements for 3,456
nuts.  They had determined that recurring demands used to compute
reorder levels for the wholesale inventory could be used to support
all requirements.

In March 1996,\6 we recommended that the Secretary of Defense direct
the Secretary of the Navy to revise policies and procedures for buy
and budget requirement computations to eliminate duplication of depot
maintenance requirements related to planned program requirements.
DOD agreed that any duplication of requirements should be eliminated,
but it disagreed that the Navy was duplicating requirements.  DOD
stated that planned program requirements and recurring demands (used
to compute reorder levels) are both needed to provide sufficient
supply support and do not overstate requirements.  Our current work
shows that this practice still results in overstated requirements and
buying more inventory than needed.

--------------------
\5 An additional $18.5 million of planned program requirements for
pack-up kits of spare parts are also duplicated in demands used to
compute reorder levels.  Because the kits are used by units when they
deploy, we excluded them from our estimate.

\6 Defense Logistics:  Requirement Determinations for Aviation Spare
Parts Need to Be Improved (GAO/NSIAD-96-70, Mar.  19, 1996).

      OTHER PURCHASES WERE NOT
      SUPPORTED
---------------------------------------------------------- Letter :3.2

Our review of the 200 items identified additional instances in which
inventory purchases were not supported by valid needs.  For example:

  -- Some purchases were made without specific requirements.  Four
     items that had $60,000 of inventory on order in excess of needs
     as of September 1996 were purchased at the direction of the
     Naval Inventory Control Point commanding officer.  According to
     the item manager, mine countermeasures systems were not
     operating because parts were not available.  As a result, the
     commanding officer directed across-the-board purchases of mine
     warfare parts for items without any inventory on hand,
     irrespective of whether or not they were needed for
     nonoperational systems.  At the time of our review, two of the
     four mine countermeasure items had $15,000 of inventory on hand
     that exceeded requirements and economic order quantities.

  -- Some purchases were based on inaccurate demand forecasts.  Four
     items (blades and vanes used to repair helicopter engines) had
     actual demands significantly less than the forecasted demands
     used to compute requirements.  In these cases, the requirements
     were based on forecasted needs of the Naval Aviation Depot,
     Cherry Point, North Carolina.  The inventory control point uses
     depot forecasts because historically the demand for blades and
     vanes has been erratic and dependent on changes in engines and
     overhaul schedules.  For one item, in January 1997, the depot
     forecasted a 1997 and 1998 requirement for 38,088 (4,761 per
     quarter) compressor rotary blades.  The forecast was used to
     compute the reorder level of 11,093 blades and an economic order
     quantity of 9,522 blades, which together resulted in a purchase
     request for 11,657 blades costing $25 each.  Although only 1,465
     blades were used between January and March 1997, the inventory
     control point did not update the depot's original forecast, but
     rather used it to compute requirements even though the forecast
     was no longer valid.  In November 1997, over $800,000 worth of
     blades and vanes were on either purchase request or contract for
     three of the items.  The item manager said that the depot's
     workload had not materialized as expected.  In January 1998,
     inventory control point officials stated that they were in the
     process of updating the demand data.

   CHANGING NEEDS CAUSED EXCESS
   INVENTORY PURCHASES
------------------------------------------------------------ Letter :4

Using the same 200 items, we performed an analysis to determine why
the Navy was purchasing inventory that exceeded needs.  For purposes
of this analysis, we assumed the Navy's requirements were valid.
Changing requirements was the most common reason for having inventory
on contract that exceeded requirements and economic order quantities.
Recurring demands had decreased, engineering estimates for
requirements had not materialized, nonrecurring demands had slipped
or were not needed, and parts had become obsolete.  In some cases,
the changes could not have been anticipated.  However, in other
cases, better management could have eliminated or minimized the
accumulation of inventory that exceeded needs.  The effectiveness of
using planned program requirements to satisfy future needs was not
measured, and purchase decisions did not adequately take into account
broken parts to be returned for repair.

      THE EFFECTIVENESS OF PLANNED
      PROGRAM REQUIREMENTS IS NOT
      MEASURED
---------------------------------------------------------- Letter :4.1

One of the uses of planned program requirements is to provide for
future nonrecurring needs for specific purposes, such as ship or
aircraft modifications that have specific dates on which the parts
are needed.  These planned program requirements are generated by
commands, such as the Naval Sea Systems Command, which is responsible
for managing naval ships and shipboard weapons and combat systems.
These requirements are added to other requirements as the date on
which a planned program item is needed nears the date on which the
item must be ordered to ensure its timely availability.  If a
customer does not requisition a planned program part, the Navy's
supply system automatically deletes the requirement.  If material to
satisfy the planned program requirement is on order or on hand,
deleting the requirement can result in excess inventory.

The Navy does not match all planned program requirements to
requisitions to determine if they are effective in satisfying future
needs.  For 13 items in our review, planned program requirements that
did not materialize contributed to excess inventory being on order
and eventually on hand.  For example, in May 1996, the Navy
contracted for one axial piston pump used to hoist and lower small
boats on mine hunter class ships.  According to the item manager,
planned program requirements for four pumps were deleted in August
and September 1996.  As of May 1997, that pump, costing $9,364, was
on hand in excess of needs.

In another case, in January 1996, the Navy contracted for two
electronic displays for the Mark 92 fire control system used on Navy
frigates and Coast Guard cutters.  According to the item manager,
four planned program requirements were deleted after the buy was
made.  As of June 1997, one display, costing $35,144, was on hand in
excess of needs.

In still another case, in April 1996, the Navy contracted for 10
rotary switches used on nuclear reactors and associated monitoring
equipment.  By October 1996, 7 of 15 planned program requirements had
failed to materialize and were deleted.  As of May 1997, five rotary
switches, costing a total of $987, were on hand in excess of needs.

The validity of planned program requirements and the accumulation of
excess inventory when these requirements do not materialize have been
long-standing problems.  In July 1993,\7 we recommended that the Navy
implement internal controls and monitoring efforts to ensure that (1)
planned program requirements are matched to customer requisitions,
(2) requirements that are delayed or deleted are analyzed to
determine the impact on purchases, and (3) procedures for validating
planned program requirements prior to taking procurement actions are
developed.  The Navy agreed with our recommendations and took
specific corrective actions to address them.

In September 1996, the Naval Supply Systems Command issued an
instruction calling for measuring the effectiveness of using planned
program requirements to satisfy customer needs.  The effectiveness
measures include matching nonrecurring demand requisitions to planned
program requirements to indicate if customers requisitioned the
material or if the requirements were deleted without being
requisitioned.  However, the Command has yet to issue specific
guidance on how to implement the effectiveness measures and they have
not been implemented.

Inventory control point officials told us that the validity of
planned program requirements continues to be a problem when customer
requisitions are not matched with these requirements.  Customers do
not requisition parts purchased to satisfy planned program
requirements and excess inventories result.

--------------------
\7 Navy Inventory:  Better Controls Needed Over Planned Program
Requirements (GAO/NSIAD-93-151, July 1, 1993).

      PARTS TO BE RETURNED FOR
      REPAIR ARE NOT CONSIDERED
---------------------------------------------------------- Letter :4.2

We identified 12 items for which broken parts' being returned for
repair contributed to excess inventory conditions.  When a customer
requisitions a repairable part, the customer frequently indicates
that a broken part will be returned at a later date.  The excess
inventory conditions occur because the broken parts to be returned
are not counted as due ins in the requirement computations.
Therefore, they are not considered in making purchase decisions.
This is also important because repairing parts generally is much
cheaper than buying new parts.  Consequently, parts are purchased
that are excess to needs, and solving customers' supply needs is more
costly than necessary.

For example, on September 30, 1996, the Navy had 85 inertial
navigation systems (for the F/A-18 and AV-8B fighter-attack aircraft)
on hand and 3 on contract.  Five of the systems, costing $97,108
each, exceeded the requirements and economic order quantity.  By
October 1997, the Navy had 109 systems on hand, of which 27 exceeded
needs.  The number of systems increased because broken system returns
exceeded customer requisitions.  Over a 2-year period, 464 broken
navigation systems were returned for repair and customers
requisitioned 372 systems, or 92 fewer than were returned.

The Navy recognizes the problem relating to the tracking of parts
being returned for repair.  A reengineering project, to be
implemented by February 1999, is aimed at accounting for the parts in
a more timely manner.  However, the project will not result in
recording broken parts as due-in inventory so that they can be
considered in purchase decisions.

   MORE PURCHASES COULD BE
   CANCELED
------------------------------------------------------------ Letter :5

We also reviewed the 200 items to determine if there was a greater
opportunity to cancel unnecessary purchases.  Our review of 200 items
with $48.3 million of inventory on contract that exceeded
requirements and economic order quantities showed that the Navy had
canceled $6.7 million of the contracts for 45 items.  However, more
cancellations could have been made.  The Navy added protection levels
of inventory, representing up to 2 years of usage, that prevented
purchases from being considered for cancellation or limited the
amount of the purchases canceled.  Additional opportunities to cancel
purchases were missed because item managers did not exercise their
responsibility to direct cancellation of contracts, economic analyses
were not made, and inventory and contracting records did not agree.

      EXCESSIVE PROTECTION LEVELS
      LIMIT CANCELLATIONS
---------------------------------------------------------- Letter :5.1

The Navy identifies purchase requests and contracts for cancellation
when quantities being purchased exceed the sum of requirements and an
added "protection level." The protection level is intended to guard
against items' fluctuating between buy and cancellation positions
because of demand changes.  The Navy defines the protection level as
the greater of
(1) 6 months or 1 year of forecasted usage for items on purchase
request and 2 years for items on contract or (2) an item's economic
order quantity.  The amount of a contract that is canceled is the
portion that exceeds the protection level.  Because the 1- or 2-year
usage often exceeds an item's economic order quantity, purchase
requests and contracts for inventory that exceed requirements often
are not considered for cancellation or the amount of a contract that
is canceled is limited by a protection level.

The 2-year usage for 86 of the 200 items exceeded the economic order
quantities.  While the items had economic order quantities valued at
$19.4 million, the 2-year usage protected $77.4 million of inventory.
In other words, the 2-year usage protected nearly four times the
amount of inventory that the Navy supply system would recommend
buying.  The economic order quantity was sufficient to prevent
fluctuations between buy and cancellation positions.  For most items,
the economic order quantity represented 6 or more months of usage
and, in some cases, exceeded the amount of inventory needed to
satisfy demand during the lead time required to purchase an item.

For 20 items, the 2-year usage protection level affected the
cancellation of $3.2 million of contracts that exceeded requirements
and economic order quantities.  For example, in June 1996, the Navy
had 308 pilot valve cartridges on contract, of which 227 exceeded
needs.  The economic order quantity was 43 cartridges but, because
the 2-year usage protection level was 168 cartridges, only 59 were
canceled.  By May 1997, all cartridges had been delivered, leaving
the Navy with 511 cartridges on hand.  Of this quantity, 261
cartridges, costing $723 each, exceeded needs and represented a
4-year supply.

In another example, in September 1997, 97 high-pressure turbine
shafts used on the engine for the FA-18 fighter-attack aircraft were
on hand and an additional 12 were on order at a cost of $9,695 each.
The Navy system did not identify this item for cancellation because
the item had a 2-year usage protection level of 84 turbine shafts,
instead of the economic order quantity protection level of 21 turbine
shafts.

      OTHER CANCELLATION
      OPPORTUNITIES WERE MISSED
---------------------------------------------------------- Letter :5.2

Opportunities to cancel contracts were missed or were not fully
explored because item managers did not exercise their responsibility
to direct cancellation of contracts, economic analyses were not made,
and the automated inventory system required contracting and inventory
files to be in agreement before accepting cancellation
recommendations.

According to inventory control point officials, item managers have
the responsibility and authority to direct cancellation of contracts.
However, item managers did not always exercise their responsibility
and authority.  Several item managers indicated that contracts were
not canceled because contracting officials rejected their attempts to
do so.  However, inventory control point officials stated that
contracting officials do not have rejection authority but merely
provide information on the status of contracts and cancellation costs
for item managers to use in making decisions.

The following example illustrates a situation where the item manager
did not exercise decision-making responsibility, but rather
interpreted the information provided by contracting as a rejection of
the cancellation attempt.  In September 1996, the Navy had 13
extender cards on contract.  The cards cost $12,180 each and are used
on nuclear parts cabinets.  The item manager said that he attempted
to cancel four cards from the contract in October 1996 and two cards
in February 1997, but contracting personnel rejected him both times
because contract deliveries were pending.  However, six cards were
still on contract in September 1997.  At that time, the requirement
was two cards and seven cards were on hand.

Economic analyses were not made to determine if contracts should be
canceled.  DOD regulations require that the cost-effectiveness of
canceling contracts be determined by comparing what it will cost to
hold items in inventory with the cost to terminate the same items
from contracts.  Although several item managers told us that
contracts for unneeded material were not canceled because
cancellation was not economical, we found no evidence that analyses
were made to determine the most economical action.  Inventory control
point officials said that in the past the Navy used an economic model
to make such decisions, but the model was no longer used because the
Navy's experience was that it generally was not economical to cancel
contracts nearing completion.

If a contract quantity that an item manager recommends for
cancellation is greater than the quantity that the contract files
show, the supply system automatically rejects the cancellation
attempt.  Partial deliveries is a major cause of the difference and
getting the inventory and contract records to match can be time
consuming and costly.  For example, in November 1996, the item
manager of an annular ball bearing used on the T-58 aircraft engine
attempted to cancel a contract for 315 bearings.  The supply system
automatically rejected the recommendation because the quantity
recommended for cancellation on the basis of the inventory records
exceeded the quantity available to cancel in the contract records.
Partial deliveries had been made but were not reflected in the
inventory records.  Several additional attempts were made to cancel
the contract, but the attempts were rejected because partial
deliveries continued and the item manager was not able to reconcile
the inventory and contract records.  By September 1997, all contract
deliveries had been made, and the Navy had 829 bearings costing $549
each on hand.  Of these, 498 exceeded the requirements and economic
order quantity.

According to inventory control point officials, the Navy has
initiated a supply system change that will allow termination of
quantities that are less than the item manager recommends because of
partial deliveries.  They expect to implement the change in September
1998.

   CONCLUSIONS
------------------------------------------------------------ Letter :6

Having inventory when it is needed is critical to maintaining
readiness and sustainability of Navy weapons and equipment.
Ineffective and inefficient inventory management practices result in
limited purchasing resources' being applied to items where there
already is sufficient inventory to support needs.  Correcting these
problems would make more funds available for those items where needs
are not being met.  While we cannot precisely quantify the overall
extent of the problems discussed in this report, we do know that the
problems affect the decision-making process for purchasing billions
of dollars of inventory.

Inventory purchases often were not based on valid needs.  The Navy
continued to count some inventory requirements twice and unnecessary
inventory purchases resulted.  Demands for planned program
requirements were also included in the reorder level requirement.
Although DOD and the Navy believe this double counting is needed, in
one case the Navy demonstrated that using the reorder level to
satisfy planned program requirements was practical and could support
all requirements.

Changing requirements was a major cause of the excess inventory on
contract.  However, better management could have minimized or
eliminated the accumulation of some inventory that exceeds needs.
For example, measuring the effectiveness of planned program
requirements in meeting future needs and accounting for broken part
returns are two areas needing improvement.

The Navy also could do a better job of canceling purchases that
exceed requirements.  Excessive protection levels, representing up to
2 years of usage, prevented purchases from being considered for
cancellation or limited the quantities canceled.  Sometimes, item
managers did not exercise their responsibility to direct cancellation
of contracts, economic analyses were not made, or inventory and
contract records did not reconcile.

Collectively, the identified problems demonstrate the need to
strengthen management oversight and controls over the processes for
determining inventory needs and canceling excess purchases.

   MATTER FOR CONGRESSIONAL
   CONSIDERATION
------------------------------------------------------------ Letter :7

Our past report and current work have demonstrated that counting
inventory requirements twice--once as planned program requirements
and again as part of the reorder level requirement--can result in
major expenditures for unnecessary inventory purchases.  Because DOD
did not agree with and took no action on our past report's
recommendation to eliminate duplication of these requirements, the
Congress may wish to consider requiring the Secretary of Defense to
direct the Secretary of the Navy to issue guidance revising the
Navy's requirements computation process to eliminate planned program
requirements that are duplicated in reorder levels.

   RECOMMENDATIONS
------------------------------------------------------------ Letter :8

We recommend that the Secretary of Defense direct the Secretary of
the Navy to strengthen management oversight procedures and internal
controls over the processes for determining inventory requirements
and canceling excess purchases.  Specifically, the Secretary of the
Navy should direct that the following actions be taken.

  -- Improve the validity of requirements by, among other things, (1)
     updating depot demand forecasts in a timely manner, (2)
     implementing current Navy guidance for measuring the
     effectiveness of using planned program requirements to satisfy
     nonrecurring demands by matching customer requisitions with
     these requirements, and (3) recording broken parts to be
     returned for repair as due ins when computing requirements.

  -- Improve the process for canceling contracts where items are
     excess to needs by (1) eliminating 1- and 2-year protection
     levels when considering purchases for cancellation, (2)
     reemphasizing to item managers that they have the responsibility
     and authority to direct cancellation of contracts, (3) requiring
     economic analyses to determine if it is economical to cancel
     contracts for excess material, and (4) automatically adjusting
     item manager cancellation recommendations when the recommended
     quantities exceed the quantities available to cancel.

   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :9

DOD partially agreed with the report and our recommendations, but did
not agree with the matter for congressional consideration (see app.
II for DOD's complete comments).

With regard to our recommendations on improving the validity of the
Navy's inventory requirements, DOD agreed with our recommendation on
effectiveness measures, partially agreed with our recommendation on
updating depot demand forecasts, and disagreed with our
recommendation to record broken parts as due-in assets.  DOD stated
that the Naval Supply Systems Command will provide detailed guidance
to the Naval Inventory Control Point on measures of effectiveness for
planned program requirements.  The inventory control point will then
develop and implement measurement tools by March 1999.

DOD agreed that Navy depot demand forecasts should be updated in a
timely manner but stated that (1) the Navy should not adjust
procurements on the basis of one quarter of demand fluctuations and
(2) demands are reviewed when making buys.  We did not recommend that
the Navy adjust procurements on the basis of one quarter of demand.
We recommended that depot demand forecasts be updated in a timely
manner.  Our point is that the item manager had not taken steps to
verify the forecasted demand.  For example, even though the depot's
workload had not materialized as expected, forecasts were not updated
11 months into the forecast period.  These items represented
inventory valued at over $800,000 on either purchase request or
contract and, as such, a more timely review and update of the demand
data could possibly have prevented excess purchases.

DOD did not agree that broken parts to be returned for repair
(referred to as carcass returns by DOD) should be recorded as due-in
assets when computing requirements.  DOD stated that parts failure
predictions are included in the requirements computation process.  We
recognize that the Navy includes these parts in requirement
computations.  However, the Navy does not include broken parts to be
returned for repair as part of the on-hand and due-in inventory that
is compared to these requirements when making purchase decisions.  To
determine how much inventory to purchase, the Navy supply demand
review process computes requirements and compares on-hand and due-in
inventory to the requirements.  By not offsetting broken parts being
returned by customers against requirements, the amount of material
needed to be purchased can be overstated.  Therefore, we made no
revisions to our recommendation.

With regard to our recommendations on improving the process for
canceling contracts where items are excess to needs, DOD agreed with
our recommendations on contract cancellation responsibilities and
cancellation quantity adjustments.  However, DOD disagreed with our
recommendations on eliminating protection levels and performing
economic analyses.  DOD stated that the Navy will reiterate contract
termination policy and procedure with its item managers and buyers
within 90 days.  The Navy plans to clearly state that item managers
have the authority and responsibility to terminate a contract when
the stock position warrants.  The Navy also will institute a policy
that a buyer may not reject a termination without written concurrence
from the item manager unless the quantity has been shipped or the
contract is already being terminated for default.  Concerning our
recommendation on cancellation quantity adjustments, the Navy noted a
change in process that would eliminate the potential for contract
terminations' being rejected.  The change relates to situations where
the quantity an item manager recommends for cancellation is greater
than what is available to terminate in the contract records.  The
change will be implemented in the first quarter of 1999.

DOD did not agree with our recommendation to eliminate protection
levels when considering whether to cancel a purchase.  DOD stated
that protection levels are justified because of the costs associated
with placing and terminating contracts and the activities associated
with buying, terminating, and buying items again (referred to as
churn by DOD).  DOD also stated that protection levels do not affect
the termination decision for most items.  Our work shows protection
levels do have a major effect on which contracts are considered for
termination.  To illustrate, 86 items had quantities valued at $58
million that were not considered for termination because of the
2-year protection level.  These quantities exceeded requirements and
economic order quantities.  Our analyses showed that economic order
quantities represented about 6 months of usage, which are sufficient
to protect against "churn." Additionally, the contracting and
termination costs DOD cited represent less than 10 percent of the
potential savings that could result from terminating a contract.  In
view of the above, we made no revisions to our recommendation.

DOD also did not agree with our recommendation that economic analyses
be performed to determine if it is economical to cancel contracts for
excess material.  DOD noted the Navy's policy to pursue the
termination of all contracts that represent excess due-in material
but stated that the Navy's past experience with an economic
termination model showed that the model did not achieve the intent of
promoting the termination of unneeded material.  We recommended that
the Navy make economic analyses, but did not specify that they use
their model.  A June 1993 DOD Inspector General report stated that
the Navy contract termination model did not use a reasonable approach
to estimating termination costs.\8 The Inspector General recommended
that DOD (1) establish specific criteria for determining the benefits
of terminating unneeded material on contract and (2) direct the
components to revise their contract termination models to conform
with the new guidance.  This is consistent with our recommendation.
In addition, while the Navy's policy is to terminate any contract
quantities considered excess, item managers told us that they
rejected several terminations because termination costs were too
high.  However, the item managers had no evidence that analyses were
made to determine if this was the most economical action.

Regarding our matter for congressional consideration, DOD did not
agree that the Navy is duplicating requirements.  DOD stated that
planned program requirements and related recurring demands are
necessary to provide separate consumer- and wholesale-level
requirements.  Our analysis shows that the requirements are counted
twice--once as planned program requirements (the consumer level to
which DOD refers) and once in computing the reorder level requirement
(DOD's wholesale level).  The duplication results in buying more
inventory than is needed and could ultimately lead to excess
inventory.  The example of the self-locking nut cited in this report
demonstrates that the Navy can successfully reduce the duplication of
requirements by relying on the reorder level requirement.  Consistent
with our past report, other duplicated requirements exist and
correcting this situation will reduce or eliminate unnecessary
spending.

--------------------
\8 Contract Terminations at DOD Wholesale Inventory Control
Activities (DOD Inspector General Audit Report No.  93-146, June 30,
1993).

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

As arranged with your office, we plan no further distribution of this
report until 15 days from its issue date unless you publicly announce
the report's contents earlier.  At that time, we will send copies of
this report to the appropriate congressional committees; the
Secretaries of Defense and the Navy; and the Director, Office of
Management and Budget.

Please contact me at (202) 512-8412 if you have any questions.  Major
contributors to this report are Charles Patton, James Murphy, Louis
Modliszewski, and David Keefer.

David R.  Warren, Director
Defense Management Issues

SCOPE AND METHODOLOGY
=========================================================== Appendix I

We analyzed September 30, 1996, inventory stratification reports for
overall data regarding Navy secondary inventory purchases.
Stratification reports match on-hand and due-in inventory to
requirements and are used for budgeting and reporting purposes.  We
did not validate the Navy's automated inventory database; however, we
did note discrepancies that were revealed during our review of
documents and discussions with item managers.  Also, Naval Audit
Service research completed in November 1997 showed that observed
demand rates often did not agree with those recorded in inventory
control point records.  In collecting data on individual sample
items, we used the same data the Navy uses for inventory management,
reporting, and budgeting purposes.

We used the data to identify Navy inventory items that had inventory
on contract or on purchase request that exceeded then-current
requirements and economic order quantities.  We identified 4,727
items that had $102.4 million of inventory on contract that exceeded
needs and 732 items with $18.2 million of inventory on purchase
requests that exceeded needs.  Purchase requests are internal
documents generated by item managers that inform contracting officers
of the need to purchase an item.  We focused our efforts on items
that were on contract because they represented the bulk of the
inventory being purchased that exceeded requirements and economic
order quantities.

We judgmentally selected 200 items with about $48 million of
inventory on contract in excess of needs (67 items with $6 million on
contract managed at the Naval Inventory Control Point's
Mechanicsburg, Pennsylvania, office and 133 items with $42 million on
contract managed at the Philadelphia, Pennsylvania, office).  We
selected items that had the highest values and quantities of
inventory on order in excess of needs, as well as a cross section of
the remaining items.  The division of items between the two inventory
control point offices was determined on the basis of the number and
value of items that exceeded requirements and economic order
quantities.

For the items, we analyzed data from the September 1996 inventory
stratification reports.  We also gathered and analyzed information
and documents from item managers on requirement computations and
efforts to cancel contracts that exceeded requirements and economic
order quantities.  We used the information and documents as a basis
for follow-up questions and discussions with item managers.  We also
met with other inventory control point officials as needed to discuss
various subjects and concepts germane to overall Navy inventory
management.  We valued inventory items at the latest acquisition
cost.

Although the review concentrated on the processes for determining
inventory needs and canceling excess purchases, past reviews
identified problems with on-hand and in-transit inventories.  For
example, in August 1996, we reported that the Navy's item managers
did not have adequate visibility over $5.7 billion in operating
materials and supplies on board ships and at redistribution sites.\1

In June 1997, the Naval Audit Service reported that quantities of
items actually in storage differed from accountable records for 21.7
percent of the items reviewed.\2 Also, in February 1998, we reported
that DOD did not have visibility over all in-transit inventory.\3

We performed our review between March 1997 and February 1998 in
accordance with generally accepted government auditing standards.

(See figure in printed edition.)Appendix II

--------------------
\1 Navy Financial Management:  Improved Management of Operating
Materials and Supplies Could Yield Significant Savings
(GAO/AIMD-96-94, Aug.  16, 1996).

\2 Fiscal Year 1996 Consolidating Financial Statements of the
Department of the Navy Business Operations Fund, Naval Audit Service
(No.  040-97, June 16, 1997).

\3 Department of Defense In-Transit Inventory (GAO/NSIAD-98-80R, Feb.
27, 1998).

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

Note:  GAO's comment
supplementing those in the
report text appear at the
end of this appendix.

(See figure in printed edition.)

See comment 1.

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

The following is GAO's comment on the Department of Defense's (DOD)
letter dated April 9, 1998.

   GAO COMMENT
--------------------------------------------------------- Appendix I:1

1.  DOD stated that many of our examples never resulted in a purchase
request because the item manager corrected the requirements data
before initiating a request.  For each of the 200 items we reviewed,
there were inventory orders on contract and those amounts on contract
exceeded requirements and economic order quantities as of September
30, 1996.  Of the examples specifically cited in the report, only two
examples discuss information that related to the initiation of a
subsequent purchase request or contract.  We used both examples to
demonstrate how the Navy double counts planned program
requirements--a matter that item managers would not review or take
corrective action on.

RELATED GAO PRODUCTS

Defense Inventory:  Inadequate Controls Over Air Force Suspended
Stocks (GAO/NSIAD-98-29, Dec.  22, 1997).

High Risk Series:  Defense Inventory Management (GAO/HR-97-5, Feb.
1997).

Defense Logistics:  Much of the Inventory Exceeds Current Needs
(GAO/NSIAD-97-71, Feb.  28, 1997).

Defense Inventory:  Spare and Repair Parts Inventory Costs Can Be
Reduced (GAO/NSIAD-97-47, Jan.  17, 1997).

Defense Logistics:  Requirement Determinations for Aviation Spare
Parts Need to Be Improved (GAO/NSIAD-96-70, Mar.  19, 1996).

Army Inventory:  Budget Requests for Spare and Repair Parts Are Not
Reliable (GAO/NSIAD-96-3, Dec.  29, 1995).

Defense Inventory:  Opportunities to Reduce Warehouse Space
(GAO/NSIAD-95-64, May 24, 1995).

Defense Supply:  Inventories Contain Nonessential and Excessive
Insurance Stocks (GAO/NSIAD-95-1, Jan.  20, 1995).

Defense Supply:  Acquisition Leadtime Requirements Can Be
Significantly Reduced (GAO/NSIAD-95-2, Dec.  20 1994).

Army Inventory:  More Effective Review of Proposed Inventory Buys
Could Reduce Unneeded Procurement (GAO/NSIAD-94-130, June 2, 1994).

Air Force Logistics:  Improved Backorder Validation Procedures Will
Save Millions (GAO/NSIAD-94-103, Apr.  20, 1994).

Air Force Logistics:  Some Progress, but Further Efforts Needed to
Terminate Excess Orders (GAO/NSIAD-94-3, Oct.  13, 1993).

Navy Inventory:  Better Controls Needed Over Planned Program
Requirements (GAO/NSIAD-93-151, July 1, 1993).

*** End of document. ***