Defense Working Capital Funds: DOD Faces Continued Challenges in
Eliminating Advance Billing (Testimony, 07/22/97,
GAO/T-AIMD/NSIAD-97-221).

GAO discussed the Department of Defense's (DOD) working capital funds,
formerly known as the Defense Business Operations Fund (DBOF), focusing
on: (1) a brief overview of fund operations and objectives; (2) a more
detailed perspective of cash management operations; and (3) GAO's
concerns with the cash situation through fiscal year (FY) 1998.

GAO noted that: (1) in creating DBOF, DOD consolidated the nine existing
industrial and stock funds operated by the military services and Defense
components into a single financial structure; (2) the primary goal of
the working capital funds is to focus the attention of all levels of
management on the total costs of carrying out certain critical DOD
business operations and the management of those costs in order to
encourage support organizations, such as depot maintenance facilities,
to provide quality goods and services at the lowest costs; (3) the
working capital funds are supposed to generate sufficient revenues to
recover expenses incurred in their operations and to operate on a
break-even basis over time; (4) to date, the working capital funds have
not yet accomplished their goal of operating on a break-even basis and
DOD estimates that they will have an accumulated operating loss of $1.7
billion at the end of FY 1997; (5) GAO remains very supportive of the
concept behind the working capital funds; (6) since 1993, the working
capital funds have experienced cash shortage and have had to advance
bill customers for work not yet performed in order to ensure that the
funds' cash balances remain positive; (7) cash generated from the sale
of goods and services is the primary means by which the working capital
funds pay their bills; (8) DOD's policy requires the funds to maintain
cash levels to cover 7 to 10 days of operational costs and 4 to 6 months
of capital asset disbursements which is about $2.3 billion to $3.4
billion for the four funds; (9) since 1993, with the transfer of $5.5
billion from DBOF as required by the National Defense Authorization Act
for Fiscal Year 1993, the funds have been advance billing customers
because they have not been able to generate enough cash to pay their
bills; (10) since 1995, the military services have made some progress in
liquidating (working off) their outstanding advance billing balances;
(11) the Army, Navy and Air Force would have had negative cash balances
when they received the responsibility for cash in February 1995 had they
not advance billed customers; (12) according to Army and Air Force
officials, they plan to liquidate all their outstanding advance billing
balances by the end of FY 1998; and (13) DOD's cash plans, dated
January/February 1997, show that the working capital funds will disburse
about $2.3 billion more that they collect during FY 1997.

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

 REPORTNUM:  T-AIMD/NSIAD-97-221
     TITLE:  Defense Working Capital Funds: DOD Faces Continued 
             Challenges in Eliminating Advance Billing
      DATE:  07/22/97
   SUBJECT:  Cash management
             Military cost control
             Decentralization
             Funds management
             Federal agency accounting systems
             Industrial funds
             Losses
             Accounting procedures
             Accountability
IDENTIFIER:  Defense Business Operations Fund
             Air Force Working Capital Fund
             Army Working Capital Fund
             Navy Working Capital Fund
             DOD Working Capital Fund
             
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Cover
================================================================ COVER


Before the Subcommittee on Military Readiness, Committee on National
Security, House of Representatives

For Release on Delivery
Expected at
2 p.m.
Tuesday,
July 22, 1997

DEFENSE WORKING CAPITAL FUNDS -
DOD FACES CONTINUED CHALLENGES IN
ELIMINATING ADVANCE BILLING

Statement of Jack L.  Brock, Jr.
Director, Defense Information and Financial Management Systems
Accounting and Information Management Division

GAO/T-AIMD/NSIAD-97-221

GAO/AIMD-97-221t


(511633, 709289)


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

  DBOF - Defense Business Operations Fund
  DOD - Department of Defense
  OSD - Office of the Secretary of Defense

============================================================ Chapter 0

Mr.  Chairman and Members of the Subcommittee: 

We are pleased to be here today to discuss the Department of
Defense's (DOD) working capital funds, formerly known as the Defense
Business Operations Fund (DBOF), which both collect and disburse over
$65 billion annually.  Specifically, our testimony will provide a (1)
brief overview of fund operations and objectives, (2) a more detailed
perspective of cash management operations, and (3) our concerns with
the cash situation through fiscal year 1998. 


   WORKING CAPITAL FUNDS
---------------------------------------------------------- Chapter 0:1

In 1991, the Department established DBOF in order to foster a more
business-like culture within selected Defense operations--including
depot maintenance, transportation, supply management, and finance and
accounting.  In creating DBOF, DOD consolidated the nine existing
industrial and stock funds operated by the military services and
Defense components into a single financial structure.  The military
services and Defense components continued to be responsible for
managing and operating business activities within the financial
structure.  In late 1996, the Under Secretary of Defense
(Comptroller) reorganized DBOF and created four working capital
funds:  Army, Navy, Air Force, and Defense-wide.  This was done in
order to clearly delineate the responsibilities of the military
services and Defense components for managing the functional and
financial aspects of their respective business areas.  The recently
established working capital funds continue to operate the same way
they did under DBOF. 

The primary goal of the working capital funds is to focus the
attention of all levels of management on the total costs of carrying
out certain critical DOD business operations and the management of
those costs in order to encourage support organizations, such as
depot maintenance facilities, to provide quality goods and services
at the lowest costs.  Focusing attention on costs is important, given
the size of the working capital funds.  For fiscal year 1998, the
four funds are expected to generate about $69 billion in revenue and
employ about 220,000 civilians and 24,000 military personnel. 

The working capital funds are supposed to generate sufficient
revenues to recover expenses incurred in their operations and to
operate on a break-even basis over time.  Essentially, each business
area establishes prices prior to the start of each fiscal year and
applies these predetermined (stabilized) prices to most orders and
requisitions received during the year.  Prices reflect expected
workload (based on customer input), costs of labor and material, and
productivity projections.  To the extent these estimates are
accurate, revenues should cover cost.  Higher-than-expected costs or
lower demand can lead to losses while the converse can lead to
profits.  Since the funds are to operate on a break-even basis over
time, profits effectively reduce prices in later years while losses
result in higher prices or surcharges. 

To date, the working capital funds have not yet accomplished their
goal of operating on a break-even basis and DOD estimates that they
will have an accumulated operating loss of $1.7 billion at the end of
fiscal year 1997.  Over the last several years, various congressional
Defense oversight and appropriations committees have expressed
concern with these losses and the management and operations of the
funds.  To address these concerns, Defense was required to conduct a
study of its working capital funds as directed in the National
Defense Authorization Act for Fiscal Year 1997.  Not later than
September 30, 1997, the Secretary of Defense is required to submit to
the Congress a plan to improve the management and performance of the
industrial, commercial, and support type activities that are
currently managed in the working capital funds. 

We remain very supportive of the concept behind the working capital
funds.  We believe the funds, even under DBOF, have achieved a
measure of success because they are doing a better job of identifying
the costs of doing business and including those costs in the prices
charged to customers.  This gives DOD managers a window into the
costs of Defense support operations--including costs for direct
labor, material, overhead, and contracts.  With a more complete cost
picture, managers can account for past activities, manage current
operations, and assess progress toward planned objectives.  In
addition, more accurate identification of costs enables those
responsible for providing oversight to make more informed policy
decisions by highlighting the cost associated with those decisions. 
We are hopeful that DOD will use its forthcoming plan as a mechanism
to continue to strengthen its commitment to improving the management
and operations of the working capital funds as well as identifying
the total costs of providing goods and services to customers and
including those costs in the prices charged customers. 


   WORKING CAPITAL FUND CASH
   MANAGEMENT
---------------------------------------------------------- Chapter 0:2

Since 1993, the working capital funds have experienced a cash
shortage and have had to advance bill customers for work not yet
performed in order to ensure that the funds' cash balances remain
positive.  In February 1995, DOD devolved the responsibility for cash
management to the military services and the Defense components to
better align accountability and responsibility for management;
however, advance billing continues and may well continue through the
next fiscal year. 


      THE IMPORTANCE OF CASH FOR
      WORKING CAPITAL FUNDS
-------------------------------------------------------- Chapter 0:2.1

Cash plays an extremely important role for DOD's working capital
funds.  Cash generated from the sale of goods and services is the
primary means by which the working capital funds pay their bills. 
Where the cash balances start each year depends on the outcome of
many decisions made during the budget process with regard to (1)
projecting workload, (2) estimating costs, and (3) setting prices to
recover the estimated full cost of the goods and services.  During
the execution of the budget, they operate much like a checking
account:  collections increase the funds' account balances and
disbursements (such as salaries and purchases of inventory) reduce
the account balances.  To the extent that the decisions made during
the budget process are reasonably accurate, the funds' cash balances
should fall between the minimum and maximum amount required by DOD. 
However, if the decisions are not accurate, the funds could have too
much or not enough cash. 

DOD's policy requires the funds to maintain cash levels to cover 7 to
10 days of operational costs and 4 to 6 months of capital asset
disbursements, which is about $2.3 billion to $3.4 billion for the
four funds.  If the level of cash becomes low and there is a
possibility of incurring an Antideficiency Act\1 violation, immediate
actions will be taken to resolve the cash shortages by advance
billing customers. 

When DBOF was established, DOD consolidated the cash balances of the
nine industrial and stock funds into a single account that was
managed centrally by the Office of the Secretary of Defense
(Comptroller).  DOD believed that managing cash at a central level
would be more effective.  However, in practice this did not work as
expected, and, in February 1995, DOD devolved responsibility for cash
management as well as Antideficiency Act responsibilities to the
military services and the Defense components.  According to DOD
officials, the cash management responsibility was devolved to the
Army, Navy, Air Force, and Defense components to better align
accountability and responsibility for managing cash.  DOD pointed out
that the operational control of actions taken by each fund activity,
which results in cash disbursements and collections, always has
resided and continues to reside with the individual Defense
components. 

We agree with DOD's decision to place the responsibility for managing
the working capital funds' cash at the military service and Defense
component level and to likewise devolve the Antideficiency Act
responsibility.  Decentralized cash management should result in a
number of benefits.  For example: 

  -- Decentralization makes each individual Defense component
     directly accountable for its respective cash balance as well as
     its decisions that affect cash, including any violation of the
     Antideficiency Act.  Each component now has an incentive to more
     accurately price the goods and services that its working capital
     fund charges customers since inaccurate prices could lead to
     insufficient cash to cover daily operating expenses. 

  -- One Defense component cannot spend money generated by another
     component.  When cash management was centralized, DOD did not
     have reports that showed the cash balances for the individual
     Defense components--the reports only provided information on (1)
     DBOF's overall cash balance and (2) collection and disbursement
     data for each of the Defense components.  With the
     decentralization of cash management, the Department of the
     Treasury provides DOD with a cash balance for each of the five
     components. 

  -- The Office of the Secretary of Defense (OSD) and the Defense
     components have started working more as a team to resolve cash
     problems.  Under centralized cash management, there was less
     incentive for the components to respond to cash problems as OSD
     had responsibility for maintaining the balance and for avoiding
     an Antideficiency Act violation.  When the components became
     responsible for their individual cash balances, they raised more
     questions on the accuracy and timeliness of the information on
     collections and disbursements.  Such increased attention should
     help improve the accuracy of collection and disbursement data
     reported in the working capital funds' financial statements
     prepared under the Chief Financial Officers Act of 1990, as
     expanded by the Government Management Reform Act of 1994.\2


--------------------
\1 The Antideficiency Act, 31 U.S.C.  1341(a)(1) provides that no
officer or employee of the government shall make or authorize an
expenditure or obligation exceeding the amount of an appropriation of
funds available for the expenditure or obligation. 

\2 Since the inception of DBOF in fiscal year 1992, the DOD Inspector
General has not been able to render a favorable audit opinion on the
fund's financial statements. 


      DOD HAS ADVANCE BILLED
      CUSTOMERS TO ALLEVIATE CASH
      SHORTAGES
-------------------------------------------------------- Chapter 0:2.2

Since 1993--with the transfer of $5.5 billion from DBOF as required
by the National Defense Authorization Act for Fiscal Year 1993--the
funds have been advance billing customers because they have not been
able to generate enough cash to pay their bills.  In July 1994, the
Comptroller of Defense stopped the advance billing at all activities
except for the Naval shipyards and research and development
activities, which had been tentatively scheduled to stop advance
billing in January 1995.  However, DOD officials informed us that
when the responsibility for cash management was returned to the
components in February 1995, the amount of cash returned to the
services was not sufficient to cover outstanding DBOF liabilities. 
DBOF's financial reports indicate that this was the case with each
service facing cash shortages.  Therefore, according to DOD, it was
necessary for the Army, Navy, and Air Force to continue to advance
bill customers so that their cash portion of DBOF would not go
negative. 

Since 1995, the military services have made some progress in
liquidating (working off) their outstanding advance billing balances. 
However, the Navy and Air Force had to advance bill customers again
during calendar years 1996 and 1997 to ensure that their cash
balances remained positive.  Specifically, the Navy advance billed
customers about $1.7 billion and the Air Force advance billed
customers $1.2 billion during calendar year 1996.  For calendar year
1997, the Navy and Air Force have advance billed their customers
about $400 million and $695 million, respectively, with most of the
billings occurring in June 1997--$230 million for the Navy and $565
million for the Air Force.  Figure 1 shows (1) the reported cash
balances for the Army, Navy, and Air Force portions of the funds and
(2) cash balances for these components if they did not advance bill
their customers from February 1995--when DOD returned the
responsibility for cash to the military services and Defense
components--through May 1997 (the charts in figure 1 only depict data
through May 1997 because working capital fund outstanding advance
billing balance data for June 1997 were not yet available).  (The
charts in figure 1 are also provided in full-page view in appendix
I.)

   Figure 1:  Working Capital Fund
   Cash Balances (Dollars in
   millions)

   (See figure in printed
   edition.)

Note:  We did not independently verify the financial information
shown in the figure, which was taken from DOD and Treasury reports. 

As figure 1 shows, the Army, Navy and Air Force would have had
negative cash balances when they received the responsibility for cash
in February 1995 had they not advance billed customers.  The figure
also shows the following. 

  -- The three military services have liquidated $4.2 billion of
     outstanding advance billings from February 1995 through May
     1997.  However, because of Navy and Air Force advance billings
     in June 1997, we are unsure of the effect these billings will
     have on the liquidation on the outstanding advance billings to
     date. 

  -- As of May 1997, the outstanding advance billing balance was
     about $1 billion.  Again, because of Navy and Air Force advance
     billings in June 1997, we are unsure of the effect these
     billings will have on the outstanding advance billing balances
     to date. 

  -- The Army has liquidated almost all of its outstanding advance
     billing balance. 

  -- The Navy's cash balance would have been negative for most of the
     period from February 1995 through May 1997 if it had not advance
     billed customers. 

  -- The Air Force liquidated most of its outstanding advance billing
     balance until it again started advance billing customers over a
     billion dollars in December 1996 to ensure that its cash balance
     would remain positive. 

According to Army and Air Force officials, they plan to liquidate all
their outstanding advance billing balances by the end of fiscal year
1998.  Navy officials informed us that they now plan to liquidate the
Navy's outstanding advance billing balance by the end of fiscal year
1999. 


      CASH OUTLOOK FOR FISCAL
      YEARS 1997 AND 1998
-------------------------------------------------------- Chapter 0:2.3

DOD's cash plans, dated January/February 1997, show that the working
capital funds will disburse about $2.3 billion more than they collect
during fiscal year 1997.  To offset most of the cash drain that DOD
expects to occur during fiscal year 1997, DOD plans to increase
fiscal year 1998 prices to recoup losses and generate cash.  DOD
plans also show that it expects to collect about $2.2 billion more
than it disburses during fiscal year 1998.  This information is
summarized in table 1. 



                                Table 1
                
                 DOD's Working Capital Fund Annual Cash
                   Plans Dated January/February 1997

                         (Dollars in millions)

                                             Estimated       Estimated
                                           fiscal year     fiscal year
                                                  1997            1998
                                           collections     collections
                                                  less            less
Component                                disbursements   disbursements
--------------------------------------  --------------  --------------
Army                                         $ (173.4)          $ 27.2
Navy                                         (1,427.7)           984.5
Air Force\a                                    (154.5)           493.4
Defense agencies                               (511.0)           669.4
======================================================================
Total                                       $(2,266.6)        $2,174.5
----------------------------------------------------------------------
\a Air Force fiscal year 1998 figure includes United States
Transportation Command's net collections of $102.6 million. 

Based on our analysis of cash and outstanding advance billing
balances, as well as past trends, we believe that the Navy and Army
may have to advance bill customers during the remainder of fiscal
year 1997 in order to ensure that their cash balances remain
positive.  This is primarily because these services' recently
reported cash balances are below the minimum required cash level. 

Further, as we have previously testified,\3 our review of five
working capital fund business areas and the assumptions used to
develop their fiscal year 1998 prices (which could change as fiscal
year 1998 approaches) indicated that the prices for four of the five
business areas may not be high enough to cover estimated fiscal year
1998 operating costs and eliminate accumulated operating losses by
over $300 million.  In developing their fiscal year 1998 prices, our
review showed that the business areas (1) overestimated productivity,
(2) set unrealistic cost-reduction goals, and (3) overestimated
workload. 

These problems are not unique to the development of the fiscal year
1998 prices.  We have previously reported\4 that these problems have
been the primary cause of some business areas reporting operational
losses.  Until DOD acts to resolve these problems, some business
areas will continue to incur losses from day-to-day operations, which
could impede DOD's ability to eliminate the practice of advance
billing. 


--------------------
\3 Defense Depot Maintenance:  Challenges Facing DOD in Managing
Working Capital Funds (GAO/T-NSIAD/AIMD-97-152, May 7, 1997). 

\4 Air Force Depot Maintenance:  Improved Pricing and Financial
Management Practices Needed (GAO/AFMD-93-5, Nov.  17, 1992); Defense
Business Operations Fund:  Improved Pricing Practices and Financial
Reports Are Needed to Set Accurate Prices (GAO/AIMD-94-132, June 22,
1994); and Navy Ordnance:  Analysis of Business Area Price Increases
and Financial Losses (GAO/AIMD/NSIAD-97-74, Mar.  14, 1997). 


-------------------------------------------------------- Chapter 0:2.4

Mr.  Chairman, this concludes our statement.  We would be pleased to
answer any questions you or Members of the Subcommittee may have at
this time. 


WORKING CAPITAL FUND CASH BALANCES
(DOLLARS IN MILLIONS)
============================================================ Chapter 1

   Figure I.1:  Overall Working
   Capital Fund

   (See figure in printed
   edition.)

Note:  Cash policy requires about $2.3 billion to $3.4 billion. 

   Figure I.2:  Army Working
   Capital Fund

   (See figure in printed
   edition.)

Note:  Cash policy requires about $360 million to $515 million. 

   Figure I.3:  Navy Working
   Capital Fund

   (See figure in printed
   edition.)

Note:  Cash policy requires about $625 million to $900 million. 

   Figure I.4:  Air Force Working
   Capital Fund

   (See figure in printed
   edition.)

Note:  Cash policy requires about $465 million to $670 million. 


*** End of document. ***