Defense Industry: Restructuring Costs Paid, Savings Realized, and Means
to Ensure Benefits (Letter Report, 12/01/98, GAO/NSIAD-99-22).

GAO reported in April 1998 that the Defense Department (DOD) estimated
it would save $3.3 billion between 1993 and 2000 from restructuring
activities carried out by seven business combinations. GAO also reported
that DOD estimated that it had realized savings of about $1.9 billion as
of August 1997, or more than half of the expected savings. Now, DOD
estimates it has realized savings of about $2.1 billion, or 64 percent
of the expected savings. Although GAO found that selected restructuring
activities have lowered the operational costs of the business
combinations by hundreds of millions of dollars, it was not feasible to
develop a methodology to precisely determine how contract prices were
affected. To make such a determination requires isolating the impact of
restructuring from nonrestructuring-related factors, such as changes in
business volume, quantities purchased, and accounting practices. DOD,
the contractors, and GAO were unable to isolate the effects of
restructuring from those of other factors. However, other methods exist
through which DOD can ensure that it receives its fair share of
restructuring savings in a timely manner.

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

 REPORTNUM:  NSIAD-99-22
     TITLE:  Defense Industry: Restructuring Costs Paid, Savings 
             Realized, and Means to Ensure Benefits
      DATE:  12/01/98
   SUBJECT:  Department of Defense contractors
             Defense procurement
             Defense cost control
             Corporate mergers
             Contract costs
             Reductions in force
             Defense economic analysis

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


Report to Congressional Committees

December 1998

DEFENSE INDUSTRY - RESTRUCTURING
COSTS PAID, SAVINGS REALIZED, AND
MEANS TO ENSURE BENEFITS

GAO/NSIAD-99-22

Restructuring Costs and Savings

(707382)


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

  DCAA - Defense Contract Audit Agency
  DCMC - Defense Contract Management Command
  DOD - Department of Defense
  UDLP - United Defense Limited Partnership

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


B-280962

December 1, 1998

Congressional Committees

Section 804 of the National Defense Authorization Act for Fiscal Year
1998\1 requires us to (1) provide updated information on
restructuring costs paid and savings realized by the Department of
Defense (DOD) from restructuring activities carried out by defense
contractor business combinations certified under Public Law 103-337,
(2) develop and use a methodology to determine the savings on the
prices paid on a meaningful sample of defense contracts, and (3) make
any recommendations considered appropriate.  This report responds to
the legislative requirement and is the last in a series of required
reports on defense contractor restructuring. 

This report includes information on the six business combinations for
which DOD, as of September 30, 1998, had certified that the projected
restructuring savings should exceed associated restructuring costs.\2
These combinations are: 

  -- United Defense Limited Partnership (UDLP), a joint venture
     between FMC Corporation's Defense Systems Group and Harsco
     Corporation's BMY Combat Systems Division;

  -- Martin Marietta Corporation's acquisition of General Electric
     Company's aerospace and other business segments;

  -- Martin Marietta's acquisition of General Dynamics Corporation's
     Space Systems Division;

  -- Northrop Corporation's acquisition of the Grumman Corporation
     and the Vought Aircraft Company to form the Northrop Grumman
     Corporation;

  -- the merger of the Lockheed Corporation and Martin Marietta to
     form the Lockheed Martin Corporation; and

  -- Hughes Electronics' acquisition of CAE-Link Corporation. 

This report also includes information on a seventh combination,
Hughes Aircraft Company's acquisition of General Dynamics' missile
operations.  This business combination occurred before the DOD
certification requirement was established; however, DOD has included
information about the combination in its annual reports to Congress
on defense contractor restructuring activities.  Accordingly, we are
including information about the combination in this report. 

We have previously reported on several aspects of defense contractor
restructuring.  See Related GAO Products at the end of this report. 


--------------------
\1 Public Law 105-85, November 18, 1997. 

\2 On October 14, 1998, DOD issued certifications related to (1)
Lockheed Martin Corporation's acquisition of most of the Loral
Corporation and (2) Westinghouse Electric Corporation's acquisition
of Norden Systems.  Norden is now part of the Northrop Grumman
Corporation, through Northrop Grumman's acquisition of Westinghouse
Electric's Electronic Systems. 


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

In April 1998, we reported that DOD estimated it would save a net of
$3.3 billion between 1993 and 2000 from restructuring activities
carried out by the seven business combinations.  We also reported
that DOD estimated it had realized savings of about $1.9 billion as
of August 1997, or more than half of the expected savings.  Now, DOD
estimates it has realized savings of about $2.1 billion, or 64
percent of the expected savings. 

While we determined that selected restructuring activities had
lowered the operational costs of the business combinations by
hundreds of millions of dollars, it was not feasible to develop a
methodology for precisely determining how contract prices were
affected.  To make such a determination requires isolating the impact
of restructuring from nonrestructuring-related factors, such as
changes in business volume, quantities purchased, and accounting
practices.  DOD, the contractors, and we were not able to isolate the
effects of restructuring from those of other factors.  However, other
methods exist through which DOD can ensure that it receives its
equitable share of restructuring savings in a timely manner. 


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

To encourage defense contractor consolidations, DOD announced in July
1993 that it would pay for restructuring costs on transferred
flexibly priced contracts,\3 provided that (1) the restructuring
costs were allowable under the Federal Acquisition Regulation and (2)
a DOD contracting officer determined that the business combination
was expected to result in overall reduced costs to DOD or preserve a
critical defense capability.  Concerns over the payment of
restructuring costs led Congress in 1994 to pass Public Law 103-337,
which required a senior DOD official to certify that projections of
restructuring savings were based on audited cost data and that the
projected savings should result in overall reduced costs to DOD. 

In 1996, Congress passed Public Law 104-208, which stipulated that
for business combinations occurring after September 30, 1996,
projected savings had to (1) be at least twice the amount of costs
allowed or (2) exceed the costs allowed, provided the Secretary of
Defense determined that the combination would result in the
preservation of a critical capability.  Public Law 105-85 made these
requirements permanent.  None of the combinations discussed in this
report were subject to the two-to-one ratio requirement because they
occurred before this requirement was established.  The Secretary of
Defense is required to report to Congress annually through 2002 on
DOD's experience with defense contractor business combinations
occurring on or after August 15, 1994. 


--------------------
\3 After a business combination, contracts are transferred from one
contractor to another through written agreements executed by the
seller, buyer, and government.  These agreements cite the
government's approval to transfer its contracts.  Flexibly priced
contracts are those under which the total amount paid to the
contractor depends on the allowable costs the contractor incurs in
performing the work. 


   RESTRUCTURING SAVINGS AND COSTS
------------------------------------------------------------ Letter :3

In April 1998, we reported that, for the seven business combinations,
DOD expects to save a net of almost $3.3 billion between 1993 and
2000 from restructuring activities, such as laying off workers,
closing facilities, and relocating employees and equipment.  Table 1
shows DOD's projection of its share of restructuring savings and
costs for these business combinations. 



                                Table 1
                
                 DOD's Projected Restructuring Savings
                               and Costs

                         (Dollars in millions)

                                                 Total             Net
                                                saving   Total  saving
Business combination                                 s   costs       s
----------------------------------------------  ------  ------  ------
Hughes -General Dynamics missile operations\a   $505.8  $132.5  $373.3
UDLP                                              79.7    29.1    50.6
Martin Marietta -General Electric Aerospace      305.4   156.3   149.1
Martin Marietta -General Dynamics Space          139.6    50.7    88.9
 Systems Division
Northrop -Grumman -Vought                        263.4    46.7   216.7
Lockheed -Martin Marietta                       2,675.   405.9  2,269.
                                                     8               9
Hughes -CAE-Link                                 148.1    35.0   113.1
======================================================================
Total                                           $4,117  $856.2  $3,261
                                                    .8              .6
----------------------------------------------------------------------
\a With the exception of Hughes - General Dynamics, all costs and
savings figures reflect the values used in DOD's certification
decisions.  Because the Hughes - General Dynamics combination
occurred before the requirement for DOD to certify that savings will
exceed costs, DOD did not prepare a comparable figure for total
restructuring savings.  The $505.8 million shown reflects DOD's share
of a March 1997 estimate of total restructuring savings; the cost
figure represents DOD's original estimate of costs. 

We reported in September 1998\4 that our work had shown that selected
restructuring activities at 10 contractor business segments had
enabled the contractors to reduce their projected operating costs by
hundreds of millions of dollars.  These reductions benefited DOD
because defense contracts' costs were lower than they would have been
if the restructuring activities had not occurred.  However, not all
of the restructuring savings shown in table 1 may be directly
attributable to restructuring. 

We noted in our April 1998 report\5 that Lockheed Martin had
projected about $489 million of restructuring savings from increased
operational efficiencies at its Missiles & Space segment by adopting
improved business practices.  Contractor officials acknowledged that
some of the improvements and associated savings could have been
implemented without restructuring because various efforts were
already underway or planned to improve the segment's operational
efficiency prior to restructuring.  However, these officials believed
that the business combination provided the means to overcome
organizational and cultural barriers that might otherwise have
hindered these efforts. 

Subsequently, we reported in September 1998 that Lockheed Martin did
not fully consider the impact of normal downsizing activities when
estimating restructuring savings.  For example, Lockheed Martin
attributed 1,153 support personnel reductions at its Missiles & Space
segment in 1995 to restructuring activities.  However, before its
merger with Martin Marietta, Lockheed had forecasted that its total
personnel level at this segment would decrease by 849 in 1995. 
Because Lockheed Martin did not consider reductions that were already
planned, the amount of savings that was directly attributed to
restructuring for 1995 may be overstated by $170 million. 

While our work raised questions as to whether all of the projected
savings are directly related to restructuring, these two
overstatements would not have affected DOD's decision to pay
restructuring costs because of the large amount of projected savings
from the Lockheed - Martin Marietta business combination. 

We reported in April 1998 that DOD estimated it had realized a net
savings of about $1.9 billion from the seven business combinations. 
Now, DOD estimates it has realized a net savings of about $2.1
billion (see table 2).  The estimated savings realized represent
about 64 percent of the restructuring savings expected at the time of
certification. 



                                Table 2
                
                DOD's Estimate of Restructuring Savings
                        Realized and Costs Paid

                         (Dollars in millions)

                                                Saving
                                                     s             Net
                                                realiz   Costs  saving
Business combination                                ed    paid       s
----------------------------------------------  ------  ------  ------
Hughes -General Dynamics missile operations\a   $505.8  $121.4  $384.4
UDLP\a                                            37.6    14.0    23.6
Martin Marietta -General Electric Aerospace\a    198.2    71.9   126.3
Martin Marietta -General Dynamics Space          163.7    26.4   137.3
 Systems Division\a
Northrop -Grumman -Vought\b                      113.0    17.5    95.5
Lockheed -Martin Marietta\b                     1,406.    49.7  1,356.
                                                     6               9
Hughes -CAE-Link\b                                37.3    13.8    23.5
======================================================================
Total                                           $2,462  $314.7  $2,147
                                                    .2              .5
----------------------------------------------------------------------
\a As of August 31, 1997. 

\b As of December 31, 1997. 

Source:  GAO analysis of DOD's most recent data, as reflected in
DOD's November 1997 and March 1998 restructuring reports,
respectively. 

We commented in the April 1998 report that caution should be
exercised when interpreting DOD's reported restructuring savings.  We
noted that the savings DOD reported were generally not developed from
a detailed analysis of the effect of restructuring on individual
contract prices but rather were estimated using the same or similar
methodologies employed to estimate savings during the certification
process.  DOD has consistently stated that it is inherently difficult
to precisely identify the amount of actual savings realized from
restructuring activities. 


--------------------
\4 Defense Contractor Restructuring:  Benefits to DOD and Contractors
(GAO/NSIAD-98-225, Sept.  10, 1998). 

\5 Defense Industry Restructuring:  Updated Cost and Savings
Information (GAO/NSIAD-98-156, Apr.  30, 1998). 


   METHODOLOGY FOR DETERMINING
   SAVINGS ON SPECIFIC CONTRACTS
   NOT FEASIBLE
------------------------------------------------------------ Letter :4

It is not feasible to develop and apply a standard methodology that
can be used to separate the precise impact of restructuring from the
impact that other factors have on contract prices.  Determining the
precise impact that restructuring activities have on a contract price
requires isolating the effect of restructuring from
nonrestructuring-related factors.  In its annual reports to Congress,
DOD has stated that factors such as inflation, business fluctuations,
accounting system changes, quantities purchased, and subsequent
reorganizations, affect a contractor's overall cost of operations. 
DOD noted that it is not feasible to precisely isolate the impact of
restructuring from the impact of these other factors.  As previously
reported, our work substantiates DOD's position. 

During our work for the September 1998 report, the contractors we
visited provided several examples that they believed demonstrated how
specific contract prices were affected by restructuring.  For
example, Martin Marietta provided information showing that the Navy
purchased 25 test equipment items at a unit price of $1,270,524
before its acquisition of the General Electric business segments and
25 of the same test equipment items at a unit price of $1,246,230
after the acquisition and subsequent restructuring.  Even though the
unit price was $24,294 lower after restructuring, neither we nor
contractor officials could isolate the impact of restructuring from
the influence of other factors, such as learning curve improvement
and business base changes.  Contractor officials believe the unit
price reduction was attributable, in part, to restructuring
activities but acknowledged that the other factors also affected the
unit price. 

A similar problem existed with the other examples provided by the
contractors.  Neither we nor the contractors could separate the
effect of restructuring from the influence of other factors that also
affected the contract prices.  Speaking on behalf of business
combinations included in our September 1998 report, the Aerospace
Industries Association noted that it was not practical to determine
the impact of restructuring on contract prices because so many
variables affect prices. 


   OTHER MEANS TO ENSURE DOD
   RECEIVES RESTRUCTURING BENEFITS
------------------------------------------------------------ Letter :5

While it is not feasible to develop a methodology to precisely
determine the impact of restructuring on contract prices, our work
has shown that there are other ways to ensure that DOD receives
benefits from restructuring activities.  In particular, prompt
adjustments of forward pricing rates\6 and the use of reopener
clauses would enable DOD to share in the benefits of restructuring in
an equitable and timely manner. 

Before DOD can benefit from restructuring activities, restructuring
savings must be incorporated into a contractor's forward pricing
rates used to price defense contracts.  DOD's acquisition regulations
stipulate that its contracting officers should adjust a contractor's
forward pricing rates as soon as practical upon receipt of a
restructuring proposal.  In commenting on our April 1998 report, DOD
highlighted this requirement by stating that, in reviewing contractor
restructuring proposals associated with business combinations, one of
its major concerns is that restructuring costs and savings are
factored into forward pricing rates as soon as possible so that the
net savings are priced into new contracts.  We strongly agree with
DOD's position.  It is imperative that contracting officers adjust
the forward pricing rates as soon as possible after a contractor
quantifies its estimated restructuring savings so that the lower
rates can be used to price contracts. 

Before forward pricing rates are adjusted and used to price
contracts, contracting officers should incorporate reopener clauses
in noncompetitive fixed-price contracts to enable DOD to recoup its
equitable share of savings under these contracts.  We reported in
July 1998\7 that it took an average of about 21 months from the
announcement of a business combination to the time that contractors
reflected restructuring savings in forward pricing rates.  During
that time, DOD awarded over 600 fixed-price contracts or contract
modifications worth about $3.9 billion to these contractors.  Despite
repeated recommendations from the Defense Contract Audit Agency
(DCAA) and the Defense Contract Management Command (DCMC),
contracting officers rarely included reopener clauses for savings in
fixed-price contracts awarded during this period. 

The use of reopener clauses has resulted in recouping restructuring
savings.  In our September 1998 report, for example, we discussed a
case where the contracting officer had included a reopener clause in
a fixed-price foreign military sales contract for self-propelled
howitzers awarded to UDLP, which required UDLP to reduce the contract
price after restructuring its operations.  Using a proposal developed
by UDLP showing the impact of restructuring on the contract, the
contracting officer negotiated a $1.8-million reduction to the
contract's $48.5-million price.  The $1.8 million could not have been
recovered from this fixed-price contract had the reopener clause not
been included in the contract at the time it was awarded. 

We reported in July 1998 that DOD contracting officers and
contractors were reluctant to use reopener clauses.  We, therefore,
recommended that the Secretary of Defense revise DOD's regulations to
require that contracting officers include the clauses in
noncompetitive fixed-price contracts negotiated before the benefits
of restructuring savings were reflected in forward pricing rates.  We
also recommended that, if the clauses were not included, contracting
officers provide a written justification in the negotiation records
as to why they were not needed. 

In responding to our recommendations, DOD agreed to add a new
provision to its regulations requiring contracting officers to
consider using a reopener clause.  DOD did not believe, however, that
the use of reopener clauses should be mandatory.  DOD stated that
contracting officers must be permitted to exercise professional
judgment to decide when the clause is appropriate.  DOD further
stated that documenting the reason for not using a reopener clause
would result in an unnecessary administrative burden and was contrary
to the principles of acquisition reform. 

DOD's action to add a new provision to its regulations requiring
contracting officers to consider using reopener clauses is a step in
the right direction.  However, we continue to believe that
contracting officers should be required to document in the
negotiation records the reason they did not include a reopener clause
in noncompetitive fixed-price contracts. 


--------------------
\6 DOD and contractors use forward pricing rates to facilitate the
pricing of contracts.  These rates are applied against a contractor's
proposed direct costs to estimate the amount of overhead costs to be
allocated to a particular contract. 

\7 Defense Contractor Restructuring:  DOD Risks Forfeiting Savings on
Fixed-Price Contracts (GAO/NSIAD-98-162, July 17, 1998). 


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

While our work has shown that DOD is benefiting from defense
contractor restructuring activities, it is not feasible to develop a
standard methodology for precisely determining the impact of these
benefits on specific contract prices.  However, DOD could ensure that
it receives its equitable share of restructuring savings in a timely
manner by having its contracting officers (1) adjust forward pricing
rates as soon as possible to reflect restructuring savings and (2)
include reopener clauses in noncompetitive fixed-price contracts
awarded before the forward pricing rates are adjusted.  DOD has
agreed to revise its regulations to require contracting officers to
consider the use of reopener clauses. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :7

DOD concurred with the report's findings.  DOD's comments are
included as appendix I. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :8

In responding to the legislative requirement, we primarily relied on
our prior work on defense contractor restructuring activities.  As
part of our prior work, we reviewed information prepared during DOD's
certification process, including the contractor's restructuring
proposal, DCAA audit reports, negotiation memorandums, and other
pertinent information to determine the amount of restructuring
savings and costs expected for each of these business combinations. 
To determine the amount of restructuring costs paid and estimated
savings realized, we reviewed DOD's November 1997 and March 1998
reports to Congress on defense industry restructuring. 

To determine the feasibility of developing a methodology for
assessing restructuring savings on individual contract prices, we
reviewed restructuring activities at 10 contractor business segments,
including at least 1 segment from each of the 7 business
combinations.  We generally selected those business segments with the
largest projected amount of restructuring savings.  In assessing
whether restructuring savings could be traced to contract prices, we
tried to compare the overhead rates that were in effect before
restructuring with the rates that were in effect after restructuring. 
We also examined contract-related documents to determine if direct
costs were less than before restructuring. 

Also, we requested that contractor officials identify comparable
items that DOD purchased before and after restructuring.  We accepted
the items the contractors identified and did not make an independent
evaluation to determine whether they identified all available
comparable items.  We compared the prices DOD paid for these items
before and after restructuring to determine if the prices had been
affected by restructuring and other factors.  In addition, we
determined whether contracting officers had included downward-only
reopener clauses in fixed-price contracts negotiated before the
contractors had adjusted their forward pricing rates to reflect the
impact of restructuring.  For those contracts containing such
clauses, we determined whether contracting officers had exercised the
clauses and, if so, the amounts by which the contracts' prices were
reduced. 

We discussed the results of our analyses with officials from the
business combinations, DOD, DCMC, and DCAA.  We performed work in
September 1998 to update some of the information included in our
prior reports.  The work was carried out in accordance with generally
accepted government auditing standards. 


We are sending copies of this report to the Secretary of Defense; the
Commander, DCMC; the Director, DCAA; and the Director, Office of
Management and Budget.  Copies will also be made available to others
upon request. 

Please contact me at (202) 512-4841 if you or your staff have any
questions concerning this report.  Major contributors to this report
are listed in appendix II. 

David E.  Cooper
Associate Director
Defense Acquisitions Issues

List of Congressional Committees

The Honorable Strom Thurmond
Chairman
The Honorable Carl Levin
Ranking Minority Member
Committee on Armed Services
United States Senate

The Honorable Ted Stevens
Chairman
The Honorable Daniel K.  Inouye
Ranking Minority Member
Subcommittee on Defense
Committee on Appropriations
United States Senate

The Honorable Floyd D.  Spence
Chairman
The Honorable Ike Skelton
Ranking Minority Member
Committee on National Security
House of Representatives

The Honorable C.  W.  Bill Young
Chairman
The Honorable John P.  Murtha
Ranking Minority Member
Subcommittee on National Security
Committee on Appropriations
House of Representatives




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================== Letter 



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

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

John K.  Harper
Timothy J.  DiNapoli
Paula J.  Haurilesko

ATLANTA FIELD OFFICE

George C.  Burdette

RELATED GAO PRODUCTS

Defense Contractor Restructuring:  Benefits to DOD and Contractors
(GAO/NSIAD-98-225, Sept.  10, 1998). 

Defense Contractor Restructuring:  DOD Risks Forfeiting Savings on
Fixed-Price Contracts (GAO/NSIAD-98-162, July 17, 1998). 

Defense Industry Restructuring:  Updated Cost and Savings Information
(GAO/NSIAD-98-156, Apr.  30, 1998). 

Defense Industry Restructuring:  Clarification of Cost and Savings
Issues (GAO/NSIAD-97-186R, June 17, 1997). 

Defense Industry Restructuring:  Cost and Savings Issues
(GAO/T-NSIAD-97-141, Apr.  15, 1997). 

Defense Restructuring Costs:  Information Pertaining to Five Business
Combinations (GAO/NSIAD-97-97, Apr.  1, 1997). 

Defense Restructuring Costs:  Projected and Actual Savings From
Martin Marietta Acquisition of GE Aerospace (GAO/NSIAD-96-191, Sept. 
5, 1996). 

Defense Contractor Restructuring:  First Application of Cost and
Savings Regulations (GAO/NSIAD-96-80, Apr.  10, 1996). 

Defense Restructuring Costs:  Payment Regulations Are Inconsistent
With Legislation (GAO/NSIAD-95-106, Aug.  10, 1995). 

Overhead Costs:  Defense Industry Initiatives to Control Overhead
Rates (GAO/NSIAD-95-115, May 3, 1995). 

Defense Downsizing:  Selected Contractor Business Unit Reactions
(GAO/NSIAD-95-114, May 3, 1995). 

Defense Industry Consolidation:  Issues Related to Acquisition and
Merger Restructuring Costs (GAO/T-NSIAD-94-247, July 27, 1994). 


*** End of document. ***