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Defense Contractor Restructuring: First Application of Cost and Saving Regulations (Letter Report, 04/10/96, GAO/NSIAD-96-80).

Pursuant to a legislative requirement, GAO reviewed the Department of
Defense's (DOD) first application of defense contractor restructuring
regulations, focusing on whether: (1) restructuring regulations were
properly carried out; and (2) the process reduced DOD costs for its
requirement for tracked combat vehicles.

GAO found that: (1) DOD generally complied with the interim
restructuring regulations the first time it applied them; (2) while the
restructuring costs paid to the contractor resulted in savings for DOD,
those savings were not as great as originally estimated; and (3)
restructuring payments to the contractor contributed to a lower unit
price for the vehicles, but it is unclear whether restructuring,
downsizing, the inflation rate, or the volume of vehicles purchased
played the greatest part in the price reduction.

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

     TITLE:  Defense Contractor Restructuring: First Application of Cost 
             and Saving Regulations
      DATE:  04/10/96
   SUBJECT:  Contract administration
             Contract costs
             Department of Defense contractors
             Defense contracts
             Defense cost control
             Defense procurement
             Contractor payments
             Military land vehicles

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================================================================ COVER

Report to Congressional Committees

April 1996



Defense Contractor Restructuring


=============================================================== ABBREV

  ACO - Administrative Contracting Officer
  DCAA - Defense Contract Audit Agency
  DCMC - Defense Contract Management Command
  DOD - Department of Defense
  TACOM - Tank -Automotive and Armaments CommandB-270798

=============================================================== LETTER


April 10, 1996

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

The Honorable Floyd Spence
The Honorable Ronald V.  Dellums
Ranking Minority Member
Committee on National Security
House of Representatives

Section 818 of the National Defense Authorization Act for Fiscal Year
1995 (P.L.  103-337) restricts Department of Defense (DOD) payments
to contractors for costs associated with business combinations. 
Specifically, it prohibits the payment of restructuring costs, such
as those associated with closing facilities and eliminating jobs,
until a senior DOD official certifies that projected savings from the
restructuring are based on audited data and should result in overall
reduced costs to DOD.  In response to section 818 requirements, DOD
issued interim regulations on restructuring costs effective December
29, 1994. 

In accordance with section 818 requirements, we reviewed the
implementation of DOD's restructuring regulations.\1 Our review
sought to determine whether the certification process was carried out
in accordance with the interim regulations and whether restructuring
had resulted in lower DOD contract prices.  We focused on the United
Defense, Limited Partnership business combination between FMC
Corporation's Defense Systems Group and Harsco Corporation's
BMY-Combat Systems Division--two manufacturers of tracked combat
vehicles for the Army.  United Defense had the first and only
restructuring proposal certified as of May 1995, when we started our
review.  This business combination is particularly significant
because the implementation of DOD's restructuring regulations at
United Defense could be a model for future restructuring efforts. 
The Defense Contract Management Command (DCMC), which has lead
responsibility for implementing DOD's restructuring regulations, is
currently tracking 30 business combinations, 7 of which involve over
$450 million in audited restructuring costs and about $1 billion in
audited restructuring savings over a 5-year period. 

To protect proprietary data, we do not disclose specific dollar
amounts applicable to any aspect of the United Defense restructuring. 

\1 As also required by section 818, we previously reported on the
adequacy of DOD's interim restructuring regulations in Defense
Restructuring Costs:  Payment Regulations Are Inconsistent With
Legislation (GAO/NSIAD-95-106, Aug.  10, 1995). 

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

DOD's actions in reviewing and certifying the United Defense
combination generally complied with the interim restructuring
regulations.  As required, the Defense Contract Audit Agency (DCAA)
reviewed United Defense's restructuring proposal, and in May 1995, a
senior DOD official certified that the restructuring should result in
overall reduced costs.  However, the projected net cost reduction
certified by DOD represents less than 15 percent of the savings FMC
and Harsco projected to DOD 2 years earlier when they sought support
for the proposed partnership. 

Subsequent to restructuring, DOD awarded United Defense a major
contract to remanufacture combat vehicles at a price less than the
price charged prior to restructuring.  Company officials believe that
most of the savings resulted from the restructuring. 

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

DOD's procurement funding for tracked combat vehicles declined by 86
percent between 1983 and 1994.  In response, FMC Corporation and
Harsco Corporation combined portions of their operations to form a
limited partnership that became effective in January 1994.  The
United Defense partnership created one of the largest U.S. 
manufacturers of armored tracked combat vehicles. 

To eliminate excess capacity and staffing resulting from the
partnership, United Defense began restructuring its operations by
combining two divisions--the California-based Ground Systems
Division, previously part of FMC, and the Pennsylvania-based Combat
Systems Division, previously part of Harsco-BMY.  United Defense is
moving the final assembly and test of most product lines from
California to Pennsylvania.  According to United Defense, the
majority of the restructuring costs are the result of this move.  The
company is also consolidating redundant staff functions, such as
finance and human resources. 

------------------------------------------------------------ Letter :3

Our review indicates that DOD's actions in approving payment of
restructuring costs for the United Defense combination generally
complied with the interim restructuring regulations, three major
elements of which are submission of a restructuring proposal, audit
of that proposal, and certification of net benefit.  United Defense
submitted the required restructuring proposal on January 3, 1995. 
The contractor's proposed savings were based entirely on workforce
reductions.  DCAA reviewed the contractor's proposal and questioned a
small portion of the costs and savings.  United Defense subsequently
agreed to reduce its proposed costs and savings by the questioned

In its audit report, DCAA pointed out that the regulations require
the Administrative Contracting Officer (ACO)\2 to immediately adjust
overhead rates upon submission of a restructuring proposal to ensure
that DOD benefits from savings projected.  The ACO instead required
United Defense to submit updated rates upon negotiation of the
restructuring proposal.  Since United Defense was not awarded any
major firm fixed-price\3 contracts before it updated the rates, DOD
was not adversely impacted by this delay.  However in future
restructuring efforts, such actions could place the government at
risk, if contracts are awarded without a downward price adjustment
clause before rates are updated. 

On May 15, 1995, the Under Secretary of Defense (Acquisition and
Technology) certified that projections of future cost savings were
based on audited cost data and should result in overall reduced cost
to DOD.  Under this projection, for every dollar in costs, DOD should
realize $2.49 in total savings, or $1.49 in net savings. 

\2 The ACO is responsible for day-to-day contract administration
functions, such as determining the allowability of contract costs and
negotiating overhead rates with the contractor, subsequent to the
award of a contract. 

\3 Under firm fixed-price contracts, the contractor agrees to furnish
supplies or services at a specified price that is not subject to
adjustment based on costs incurred. 

------------------------------------------------------------ Letter :4

Projected net savings at the time of DOD certification represent less
than 15 percent of the estimate FMC and Harsco originally presented
to DOD.  In late 1992, the companies requested Army financial support
for the proposed partnership, in terms of sharing the costs of
restructuring, as the Army stood to benefit from the partnership. 
According to FMC, the consolidation of manufacturing and overhead
functions would lower the Army's product costs.  The companies
projected that every dollar in restructuring costs would generate
over $10.00 in net savings.  To put this projection into perspective,
the Deputy Secretary of Defense advised a congressional subcommittee
in mid-1994 that based on rough data estimated projected savings for
four restructurings at that time ranged from one and a half to seven
times the projected cost.  Later in these hearings, however, the
Deputy Secretary told the subcommittee that future restructuring
savings could range from four to seven times the projected cost.  In
other words, for every dollar DOD invests in restructuring costs, it
could realize savings from $1.50 to $7.00. 

Several factors account for the difference between the original
savings estimate of $10.00 and the current estimate of $1.49.  For
example, the initial estimate was based on reductions in specific
elements of cost, including overhead, manufacturing, and material. 
In addition, the initial estimate included savings from improved
facility utilization resulting from potential increases in foreign
sales.  However, because section 818 and DOD's implementing
regulations only required that United Defense demonstrate that
restructuring should result in reduced costs, United Defense chose to
base its current estimate solely on elements of cost related to
workforce reductions.  Also, the initial estimate was spread over an
8-year period and was adjusted for inflation, while the current
estimate was spread over 5 years and was not adjusted for inflation. 
DCMC and DCAA guidance issued subsequent to the initial estimate
indicated that savings should be calculated over a 5-year period.  In
addition, the initial estimate was considered a
rough-order-of-magnitude, according to DOD officials. 

------------------------------------------------------------ Letter :5

At the time of our review, DOD had awarded United Defense only one
new contract that was comparable to a contract awarded prior to
restructuring.  In that one contract, United Defense's restructuring
efforts did contribute to a reduction in the unit price, but the
precise amount of savings resulting from restructuring cannot be
determined.  U.S.  Army Tank-Automotive and Armaments Command (TACOM)
officials compared the negotiated unit price of that one contract, a
follow-on remanufacturing contract that included the effects of
restructuring, to the unit price of the initial contract that did not
include the effects of restructuring.  According to TACOM officials,
the unit price of the follow-on contract was 11 percent lower than
the initial contract price, not adjusted for inflation.  TACOM's
analysis was based on the basic contract for 172 vehicles.  According
to United Defense officials, the follow-on unit price was 16 percent
lower, adjusted for inflation.  United Defense's analysis was based
on the basic contract plus options, for a total of 272 vehicles. 

Our analysis indicated that savings could range from 8 to 16 percent. 
The range of savings in these three sets of estimates is due
primarily to differences in estimates of the number of units to be
remanufactured and the inflation rate used to adjust the unit price
of the initial contract.  The 8-percent savings estimate was based on
the basic contract and not adjusted for inflation, as with TACOM's
estimate.  The 16 percent savings was based on the inflation rate
United Defense used in its analysis--approximately 2.6 percent per
year over a 2-year period--and the basic contract plus the options. 

TACOM officials believe that the reduction in unit price was due to
both restructuring and downsizing, which would have occurred absent
the restructuring.  United Defense officials believe that the vast
majority of the savings was due to lower costs resulting from
restructuring.  Nevertheless, our analysis illustrates the
sensitivity of the projected savings to the inflation rate and the
number of vehicles purchased. 

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

In commenting on a draft of this report, DOD concurred with the
report.  DOD suggested two technical clarifications and we have
incorporated them in the text where appropriate.  DOD's comments are
presented in their entirety in appendix I. 

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

To assess DOD's compliance with the interim restructuring
regulations, we analyzed United Defense's restructuring proposal, the
DCAA audit report on that proposal, and other documents.  We also
discussed restructuring activities with officials from United
Defense, DCMC, DCAA, TACOM, and offices of the Director of Defense
Procurement, the Secretary of the Army, and the DOD Inspector
General.  In addition, we examined information on overhead rates,
business volumes, and unit prices at two United Defense plant sites
and at TACOM. 

To determine the impact of restructuring on DOD contract prices, we
examined all contracts awarded after restructuring that were
potentially comparable to those awarded prior to restructuring.  We
calculated the unit price of the only comparable contract, which did
not include the effects of restructuring, and compared it to the unit
price of the only similar contract that included the effects of
restructuring.  Furthermore, we evaluated similar calculations and
comparisons made by United Defense and TACOM officials to determine
the bases for differences in estimates of savings. 

We performed our review between May 1995 and January 1996 in
accordance with generally accepted government auditing standards. 

---------------------------------------------------------- Letter :7.1

We are sending copies of this report to the Chairmen of the Senate
Committee on Governmental Affairs, the House Committee on Government
Reform and Oversight, and the House and Senate Committees on
Appropriations and on the Budget; the Secretaries of Defense and the
Army; the Commander, DCMC; the Director, DCAA; and the Chief
Executive Officer, United Defense.  We will also provide copies to
others upon request. 

Please contact me at (202) 512-4587 if you or your staff have any
questions concerning this report.  The major contributors to this
report were John K.  Harper, George C.  Burdette, Anne-Marie Olson,
and Kelly A.  Davis. 

David E.  Cooper
Associate Director, Defense Acquisitions Issues

(See figure in printed edition.)Appendix I
============================================================== Letter 

(See figure in printed edition.)

*** End of document. ***