FAS | Military Analysis | GAO |||| Index | Search |


Defense Industry Restructuring: Updated Cost and Savings Information (Letter Report, 04/30/98, GAO/NSIAD-98-156).

Pursuant to a legislative requirement, GAO provided information on
restructuring costs of defense contractors involved in business
combinations since 1993, focusing on the: (1) specific costs associated
with workforce reductions; (2) services provided to workers affected by
business combinations; (3) savings reached from the business
combinations relative to the restructuring costs paid by the Department
of Defense (DOD); and (4) budgetary implications of reported
restructuring savings.

GAO noted that: (1) the seven business combinations estimated they had
spent $1.2 billion at the same time of GAO's review for such
restructuring activities as the disposal and relocation of facilities
and equipment, consolidation of operations and systems, relocation of
employees, and workforce reductions; (2) severance pay constituted the
majority of these expenses, with less amounts provided for temporary
health benefits and outplacement services; (3) outplacement services
included career transition workshops, resume development, career
counseling services, job listings, and information on state and federal
programs; (4) overall, the business combinations reported that about
18,000 workers or positions were eliminated due to restructuring
activities; (5) DOD estimated it would realize a net benefit of about
$3.3 billion from certified restructuring activities; (6) further, DOD
estimated that as of August 1997 it had realized a net savings of about
$1.9 billion, or more than half of the certified amount; (7) however,
DOD's figures may overstate the amount that is directly attributable to
restructuring; (8) the lack of specific DOD guidance on evaluating
savings may contribute to this condition; (9) caution should be
exercised when using or interpreting estimates of restructuring savings;
(10) in a budgetary context, the $3.3 billion of estimated restructuring
savings represents a cumulative amount of savings for each business
combination, often spread over a 5-year period; (11) such savings
constituted less than 1 percent of DOD's research and procurement
budgets over the period for which the savings were projected; (12) with
one exception, DOD officials told GAO they did not consider
restructuring savings when formulating DOD's budget requests; (13) the
one case cited by DOD involved two Air Force and Navy missile programs;
(14) while DOD had initially proposed reducing the programs' budgets to
reflect anticipated restructuring savings, DOD subsequently agreed with
the military services that the projected savings were needed to fund
other program-related needs; and (15) in cases in which restructuring
activities influenced a particular weapon system's cost, projected
savings were often offset by nonrestructuring-related events.

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

 REPORTNUM:  NSIAD-98-156
     TITLE:  Defense Industry Restructuring: Updated Cost and Savings 
             Information
      DATE:  04/30/98
   SUBJECT:  Department of Defense contractors
             Defense cost control
             Defense procurement
             Defense economic analysis
             Advanced weapons systems
             Human resources utilization
             Employment or training programs
             Reductions in force
             Severance pay
             Defense budgets

             
******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO report.  Delineations within the text indicating chapter **
** titles, headings, and bullets are preserved.  Major          **
** divisions and subdivisions of the text, such as Chapters,    **
** Sections, and Appendixes, are identified by double and       **
** single lines.  The numbers on the right end of these lines   **
** indicate the position of each of the subsections in the      **
** document outline.  These numbers do NOT correspond with the  **
** page numbers of the printed product.                         **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
** A printed copy of this report may be obtained from the GAO   **
** Document Distribution Center.  For further details, please   **
** send an e-mail message to:                                   **
**                                                              **
**                    <[email protected]>                        **
**                                                              **
** with the message 'info' in the body.                         **
******************************************************************


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


Report to Congressional Committees

April 1998

DEFENSE INDUSTRY RESTRUCTURING -
UPDATED COST AND SAVINGS
INFORMATION

GAO/NSIAD-98-156

Defense Restructuring Cost and Savings

(707349)


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

  AMRAAM - advanced medium range air-to-air missile
  DCAA - Defense Contract Audit Agency
  DCMC - Defense Contract Management Command
  DOD - Department of Defense
  UDLP - United Defense Limited Partnership

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


B-279390.2

April 30, 1998

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

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

Section 8092 of the Department of Defense (DOD) Appropriations Act,
1998,\1 required us to report by April 1, 1998, on restructuring
costs of defense contractors involved in business combinations since
1993.  This is a non-proprietary version of our April 1, 1998,
proprietary report. 

The legislation required us to analyze the specific costs associated
with workforce reductions, the services provided to workers affected
by business combinations, and the savings reached from the business
combinations relative to the restructuring costs paid by DOD.  This
report provides the requested information and also discusses the
budgetary implications of reported restructuring savings.\2

The legislation also requested that we analyze the effectiveness of
the services provided to assist laid-off workers gain new employment. 
In our April 1997 report on defense restructuring costs, we described
the factors that precluded us from determining the effectiveness of
such services.\3

Consequently, as agreed with your offices, we limited our efforts in
this area.  We did, however, obtain descriptive information on the
assistance provided by business combinations and included such
information, as appropriate, in this report. 

To accomplish our work, we obtained information in February 1998 on
six business combinations for which DOD certified that the proposals'
estimated savings will exceed their projected costs.  These
combinations include: 

  -- the 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 Space Systems
     Division;

  -- Northrop Corporation's acquisitions 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. 

We also obtained information pertaining to a seventh combination,
Hughes Aircraft Company's acquisition of General Dynamics' missile
operations.  This combination was consummated prior to the
requirement for DOD to certify that savings will exceed costs. 
However, DOD has included this combination in its reports to Congress
on defense industry restructuring. 


--------------------
\1 Public Law 105-56, October 8, 1997. 

\2 Section 804 of the National Defense Authorization Act for Fiscal
Year 1998 requires us to provide updated information on restructuring
costs paid and savings realized by DOD by December 1, 1998. 

\3 Defense Restructuring Costs:  Information Pertaining to Five
Business Combinations (GAO/NSIAD-97-97, Apr.  1, 1997). 


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

In July 1993, DOD changed a long-standing practice and permitted
defense contractors to charge restructuring costs to transferred\4
flexibly priced\5 contracts, provided (1) the restructuring costs
were allowable under the Federal Acquisition Regulation and (2) a DOD
contracting officer determined the business combination would result
in overall reduced costs to DOD or preserve a critical defense
capability. 

Concerns over the payment of such costs led Congress to pass
legislation requiring that certain conditions be met before DOD
reimbursed defense contractors for restructuring-related expenses.\6

The legislation required, in part, that

  -- a senior DOD official certify that projections of restructuring
     savings are based on audited cost data;

  -- DOD's share of projected savings exceeds allowed costs; and

  -- the Secretary of Defense reports to Congress on DOD's experience
     with defense contractor business combinations, including whether
     savings associated with each restructuring actually exceed
     restructuring costs. 

The Secretary of Defense is currently required by 10 U.S.C.  2325 to
determine in writing that the savings will be at least twice the
amount of allowed costs or that projected savings will exceed costs
allowed and that the combination will result in the preservation of a
critical capability. 

DOD's process to comply with these provisions requires, in part, that
(1) the contractor submit a restructuring proposal, including details
on planned restructuring activities, their projected costs, and
anticipated savings; (2) the Defense Contract Audit Agency (DCAA)
audits the proposal; and (3) following the audit, a DOD contracting
official recommends whether the proposal should be certified. 
Assuming a favorable recommendation, a senior DOD official issues a
written certification stating that projected savings should exceed
the projected costs.  The certification enables the contractor to
bill restructuring costs to DOD and, in turn, allows DOD to reimburse
the contractor for DOD's share of such costs. 

Through December 31, 1997, DOD issued nine certifications for
restructuring proposals associated with six business combinations. 
DOD officials indicated that another six restructuring proposals are
in various stages of review within DOD, and several significant
business combinations may result in future restructuring proposals. 
This latter category includes Raytheon's acquisition of the defense
units of Texas Instruments and Hughes Electronics, respectively, and
the merger of Boeing and McDonnell Douglas. 


--------------------
\4 Following a business combination, contracts may be transferred
from one contractor to another through a written agreement executed
by the seller, buyer, and government, under which the government
agrees to the transfer of its contracts. 

\5 Flexibly priced contracts comprise a family of contracts under
which the total amount paid to the contractor is dependent upon the
allowable costs the contractor incurs in performing the contract. 

\6 Public Law 103-337, µ 818, October 5, 1994. 


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

The seven business combinations estimated they had spent $1.2 billion
at the time of our review for such restructuring activities as the
disposal and relocation of facilities and equipment, consolidation of
operations and systems, relocation of employees, and workforce
reductions.  Of this amount, the business combinations spent about
$115 million on expenses related to workforce reductions.  Severance
pay constituted the majority of these expenses, with less amounts
provided for temporary health benefits and outplacement services. 
Outplacement services included career transition workshops, resume
development, career counseling services, job listings, and
information on state and federal programs.  Overall, the business
combinations reported that about 18,000 workers or positions were
eliminated due to restructuring activities. 

DOD estimated it would realize a net benefit of about $3.3 billion
from certified restructuring activities.  Further, DOD estimated that
as of August 1997 it had realized a net savings of about $1.9
billion, or more than half of the certified amount.  However, DOD's
figures may overstate the amount that is directly attributable to
restructuring.  The lack of specific DOD guidance on evaluating
savings may contribute to this condition. 

Caution should be exercised when using or interpreting estimates of
restructuring savings.  In a budgetary context, the $3.3 billion of
estimated restructuring savings represents a cumulative amount of
savings for each business combination, often spread over a 5-year
period.  Such savings constituted less than 1 percent of DOD's
research and procurement budgets over the period for which the
savings were projected.  With one exception, DOD officials told us
they did not consider restructuring savings when formulating DOD's
budget requests.  The one case cited by DOD involved two Air Force
and Navy missile programs.  While DOD had initially proposed reducing
the programs' budgets to reflect anticipated restructuring savings,
DOD subsequently agreed with the military services that the projected
savings were needed to fund other program-related needs.  In cases in
which restructuring activities influenced a particular weapon
system's cost, projected savings were often offset by
nonrestructuring-
related events. 


   RESTRUCTURING COSTS
------------------------------------------------------------ Letter :3

For the seven business combinations we examined, certified
restructuring costs totaled about $1.5 billion.  At the time of our
review, the businesses estimated they had spent about $1.2 billion
(see table 1).  Restructuring costs are allocated to all of a
contractor's customers; consequently, DOD's portion of these costs
depends on its share of the contractor's total business base.  Based
on estimates made at the time of certification, DOD projected it
would pay about 56 percent of the restructuring costs. 



                                Table 1
                
                 Certified and Estimated Restructuring
                  Costs of Seven Business Combinations

                         (Dollars in millions)

                                                             Estimated
Business combination                           Certified          cost
------------------------------------------  ------------  ------------
Hughes-General Dynamics                         $366.1\a        $319.1
UDLP                                                36.4          38.5
Martin Marietta-General Electric                   241.6         233.9
Northrop-Grumman-Vought                             70.4          75.1
Martin Marietta-General Dynamics                    71.4          63.0
Lockheed-Martin Marietta                           686.5         419.5
Hughes-CAE Link                                     50.1          38.7
======================================================================
Total                                           $1,522.5      $1,187.8
----------------------------------------------------------------------
\a Costs for the Hughes-General Dynamics combination were not subject
to the certification process. 

Restructuring after a business combination includes a wide range of
activities, such as the disposal and modification of facilities,
consolidation of operations and systems, relocation of workers and
equipment, and workforce reductions.  We grouped the estimated amount
of restructuring costs incurred by the seven business combinations
into broad categories (see table 2).  Of the $1.2 billion in
estimated restructuring costs, disposal and relocation of facilities
and equipment was the largest cost category. 



                                Table 2
                
                    Estimated Restructuring Costs by
                                Category

                         (Dollars in millions)

Category                                                Estimated cost
------------------------------------------------------  --------------
Nonemployee-related cost
Disposal, modification, or relocation of facilities             $547.4
 and equipment
Consolidation of operations and systems                           93.7
Restructuring planning and implementation                        124.8
Other                                                            146.3
Cost for employees remaining with company
Relocation                                                       140.4
Retraining                                                        10.5
Other                                                              9.3
Cost of benefits and services for laid-off workers
Severance pay                                                     95.8
Continuation of health benefits                                    4.1
Outplacement services                                              4.1
Other                                                             11.4
======================================================================
Total                                                         $1,187.8
----------------------------------------------------------------------

   IMPACT ON DEFENSE WORKERS
------------------------------------------------------------ Letter :4

The seven business combinations included in our review projected that
about 21,000 workers or positions would be eliminated as a result of
restructuring activities.  The business combinations also reported
that, at the time of our review, about 18,000 workers or positions
had actually been eliminated (see table 3). 



                                Table 3
                
                 Projected and Actual Number of Workers
                 or Positions Eliminated as a Result of
                             Restructuring

Business combination                           Projected        Actual
------------------------------------------  ------------  ------------
Hughes-General Dynamics                            6,600         6,441
UDLP                                                 483           500
Martin Marietta-General Electric                   1,453         1,504
Northrop-Grumman-Vought                              450           450
Martin Marietta-General Dynamics                   1,150         1,250
Lockheed-Martin Marietta                          10,678         7,049
Hughes-CAE Link                                      548           665
======================================================================
Total                                             21,362        17,859
----------------------------------------------------------------------
While the job losses attributed to restructuring are significant, the
losses reflect the overall downsizing in defense-related employment. 
DOD estimates that defense-related industry employment will decrease
from about 2.7 million workers in 1993 to about 2.1 million workers
by the end of 1998. 


      COSTS OF BENEFITS AND
      SERVICES PROVIDED TO
      LAID-OFF WORKERS
---------------------------------------------------------- Letter :4.1

The seven business combinations estimated they spent about $115.4
million·or about 10 percent·of the total restructuring costs for
benefits and services associated with workforce reductions.  The
majority of these costs were for severance pay, with less amounts for
temporary health benefits and outplacement services.  Outplacement
included such services as career transition workshops, resume
development, career counseling services, job listings, and
information on state and federal programs.  The costs for worker
benefits and services varied by business combination, ranging from 3
percent to 14 percent of the combination's total restructuring costs. 

A key determinant in whether laid-off workers received severance
payments was whether the company provided such benefits prior to the
business combination.  For example, General Dynamics, Northrop, and
the Vought corporations did not provide severance benefits to their
workers prior to the combination; consequently, workers who were laid
off as a result of restructuring received no severance benefits from
their former employer.  For those companies that provided severance
pay, the amount varied, depending on such factors as whether the
workers were salaried or hourly employees and the length of time they
had been with the corporations. 

Laid-off workers may also be provided benefits and services that were
not funded by DOD.  For example, the state of California, through the
San Diego Consortium and the Private Industry Council, awarded Martin
Marietta $935,000 to assist General Dynamics' laid-off employees. 


   SOME REPORTED SAVINGS MAY NOT
   BE DIRECTLY ATTRIBUTABLE TO
   RESTRUCTURING
------------------------------------------------------------ Letter :5

Each of the combinations that sought payment for restructuring
activities was required to demonstrate that DOD's share of the
estimated savings from the restructuring would exceed DOD's share of
the projected costs.  Overall, DOD estimates that it should realize a
net savings of about $3.3 billion from restructuring activities (see
table 4).  DOD's figures indicate that for each dollar of
restructuring costs it expects to pay, it will receive about $4.81 in
benefits.  However, not all of the reported savings may be directly
attributable to restructuring. 



                                Table 4
                
                 DOD's Share of Projected Restructuring
                           Costs and Savings

                         (Dollars in millions)

Business
combination     Savings         Cost      Net savings       Ratio
------------  ------------  ------------  ------------  --------------
Hughes-          $505.8        $132.5        $373.3        3.82 -1
 General
 Dynamics\a
UDLP              79.7          29.1          50.6         2.74 -1
Martin           305.4         156.3         149.1         1.95 -1
 Marietta-
 General
 Electric
Northrop-        263.4          46.7         216.7         5.64 -1
 Grumman-
 Vought
Martin           139.6          50.7          88.9         2.75 -1
 Marietta-
 General
 Dynamics
Lockheed-       2,675.8        405.9        2,269.9        6.59 -1
 Martin
 Marietta
Hughes-CAE       148.1          35.0         113.1         4.23 -1
 Link
======================================================================
Total           $4,117.8       $856.2       $3,261.6       4.81 -1
----------------------------------------------------------------------
\a With the exception of Hughes-General Dynamics, all costs and
savings figures reflect the values used in DOD's certification
decision.  As the Hughes-General Dynamics combination occurred prior
to 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 in table 4 reflects DOD's share of
a March 1997 estimate of total restructuring savings; the cost figure
represents DOD's original estimate of costs. 

DCAA's guidance on auditing restructuring proposals may not provide
sufficient criteria to ensure that the proposed savings are directly
due to restructuring.  DCAA's guidance discusses at length factors to
consider in evaluating proposed costs, but it provides far less
guidance on evaluating savings.  Relative to evaluating projected
restructuring savings, the guidance notes that contractor
restructuring efforts are intended to result in the combinations of
facilities, operations, or workforce that eliminate redundant
capabilities, improve future operations, and reduce overall costs. 
It further notes that it is the contractor's responsibility to
establish and support the reasonableness of the baseline to measure
restructuring savings, but notes that various techniques can be used
to do so.  Finally, the guidance requires DCAA auditors to ensure
that the estimates of future savings are reasonable and not due to
other factors, such as changes in inflation or interest rates. 

This broad framework may result in DOD's accepting proposed savings
that are not directly attributable to restructuring.  For example, as
part of our ongoing work at Lockheed Martin's Space and Strategic
Missiles sector, we attempted to isolate the effects of restructuring
from nonrestructuring- related activities.  The overall savings from
this sector are considerable, amounting to about 43 percent of the
total amount of projected restructuring savings from the seven
combinations in our review.  Of the savings accepted by DOD for
certification purposes, about $489 million was attributed to
increased operational efficiencies at one location through the
adoption of improved business practices. 

Contractor officials acknowledged that some of the improvements and
associated savings could have been implemented without restructuring,
noting that the contractor had various efforts to improve its
operational efficiency underway or planned 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.  A senior Lockheed
Martin official emphasized that the merger provided the company a
unique opportunity to evaluate and implement the best practices from
four Lockheed and Martin Marietta facilities. 

DCAA officials told us that during their audit of the restructure
proposal for certification, they did not consider whether such
savings could have been accomplished in the absence of restructuring. 
They noted, however, that they did not believe that DCAA's guidance
provides sufficient criteria to distinguish savings attributable to
restructuring from those savings that would have occurred regardless
of the restructuring. 

The Department of Justice and the Federal Trade Commission face a
similar issue during their reviews of proposed mergers and
acquisitions.  In April 1997, the agencies issued revised guidance
that discusses the types of efficiencies they consider germane to
their reviews.  In general, while the agencies will consider savings
as part of their analysis, these agencies consider only those savings
that are specific to the merger and that are unlikely to be
accomplished in the absence of the merger.  For example, the guidance
notes that efficiencies resulting from shifting production among
facilities formerly owned by the separate firms are more likely to be
related to the merger.  On the other hand, the guidance notes that
other efficiencies, such as those relating to management
improvements, are less likely to be specifically related to the
merger.  In our view, while evaluating proposed savings requires
flexibility and the use of professional judgment, reflecting a
similar approach in DCAA's guidance would provide a better depiction
of the impact of restructuring activities. 


   ESTIMATING ACTUAL SAVINGS
   INHERENTLY DIFFICULT
------------------------------------------------------------ Letter :6

While DOD reports to Congress its estimates of whether savings
associated with each business combination actually exceed
restructuring costs, it acknowledges that making accurate estimates
is inherently difficult.  DOD reported that, as of August 1997, it
had reimbursed defense contractors approximately $294.3 million in
restructuring-related expenses, while it estimated that savings of
about $2.2 billion had been realized (see table 5).  As a result, DOD
estimated that it has realized a net benefit of about $1.9 billion,
or more than half the $3.3 billion in net savings certified for the
seven business combinations.  The savings reported by DOD were
generally not developed from a detailed analysis of the effect of
restructuring on individual contract prices, but rather were
calculated using the same or similar methodologies employed during
the certification process. 



                                Table 5
                
                   DOD Estimates of Its Share of Paid
                Restructuring Costs and Realized Savings
                         as of August 31, 1997

                         (Dollars in millions)

                                              Paid  Realized       Net
Business combination                          cost   savings   savings
----------------------------------------  --------  --------  --------
Hughes-General Dynamics                     $121.4  $505.8\a    $384.4
UDLP                                          14.0    37.6\b      23.6
Martin Marietta-General Electric              71.9     198.2     126.3
Northrop-Grumman-Vought                       14.5    98.2\c      83.7
Martin Marietta-General Dynamics              26.4     163.7     137.3
Lockheed-Martin Marietta                      35.3  1,118.4\   1,083.1
                                                           d
Hughes-CAE Link                               10.8      32.1      21.3
======================================================================
Total                                       $294.3  $2,154.0  $1,859.7
----------------------------------------------------------------------
\a The report indicated that the Hughes-General Dynamics savings
related to only eight contracts; however, the estimate was for the
total business combination. 

\b DCAA reported that the UDLP savings were inadvertently overstated
by about $10.3 million. 

\c Estimated savings are based on two of the six projects certified. 
These two projects accounted for 90 percent of total projected
savings. 

\d The estimated savings reflect about $869 million attributed to
restructuring activities at two of Lockheed Martin's business units. 
At one unit, due to time constraints, DCAA limited its review to
determining whether the claimed savings were consistent with those
accepted during certification, and did not verify savings to specific
contracts or verify the accuracy of the amounts claimed.  To a lesser
degree, time constraints also limited DCAA's efforts at the other
unit.  However, DCAA did reject about 13 percent of the savings
claimed by Lockheed Martin at these locations. 

Caution should be exercised when interpreting the reported savings. 
DOD has consistently said that it is inherently difficult to
precisely identify the amount of actual savings realized through
restructuring activities several years after the initial estimate. 
For example, DOD has stated it is not feasible to completely isolate
the effects of restructuring from such other factors as fluctuations
in a contractor's business base, changes in the inflation rate,
accounting system changes, subsequent reorganizations, and unexpected
events, which also impact a contractor's cost of operations. 
Recognizing such difficulties, DOD initially agreed that it would not
require validation of the projected savings for two business
combinations, noting in one agreement that such a validation was not
practical because of business dynamics and future uncertainties. 
However, DOD estimates actual savings resulting from these two
business combinations in response to the reporting requirement. 

The difficulty in isolating the effect of nonrestructuring activities
and their impact on estimating savings is illustrated by
restructuring activities following Martin Marietta's acquisition of
General Dynamics Space Systems Division.  In this case, DCAA used a
different business base in estimating actual restructuring savings
than was used to estimate the certified savings.  The use of a
different business base led, in part, to DOD's share of net savings
shown in table 5·$137.3 million·being considerably higher than the
$88.9 million of net savings expected at certification.  DCAA
officials told us that they were unaware of any way to isolate
changes in Martin Marietta's current business base to make it
comparable to that used during the certification process. 


   IMPACT OF RESTRUCTURING SAVINGS
   ON DOD BUDGET REQUIREMENTS HAS
   BEEN LIMITED
------------------------------------------------------------ Letter :7

The impact of restructuring savings on DOD's budget requirements has
been limited.  Projected savings constituted a small percentage of
DOD's budgets and were generally not considered by DOD officials in
formulating budget requests.  Also, even when restructuring
activities influenced a weapon system's cost, the impact was often
offset by nonrestructuring- related events or used to fund other
program-related needs. 

DOD's estimate of restructuring savings·which includes those savings
that may not be directly related to restructuring·represents a
cumulative amount of savings, often spread over a 5-year period, for
each business combination.  Overall, DOD estimated it would realize a
net savings of about $3.3 billion between 1993 and 2000.\7 In
comparison, DOD's approved or projected budgets for research and
procurement totaled more than $658 billion over that same period. 
Consequently, DOD's share of certified savings constitutes less than
1 percent of DOD's budgets. 

A senior DOD budget official stated that DOD generally has not
considered restructuring savings when formulating its budget requests
and relied on the individual program offices to do so.  He
acknowledged, however, that DOD's budget guidance does not
specifically require the program offices to consider restructuring
savings.  This official also told us that the one exception that he
was aware of involved Raytheon's recent acquisition of Hughes'
defense business, for which DOD considered reducing the projected
budgets for the advanced medium range air-to-air missile (AMRAAM), a
joint Air Force/Navy program, and the Navy's standard missile program
to reflect anticipated savings.  Regarding the AMRAAM, Air Force
officials argued that any savings that resulted from the business
combination were needed to fund future programmatic needs.  According
to Navy officials, the savings were used to budget for additional
missiles for both programs.  DOD subsequently agreed not to reduce
the proposed budgets to reflect restructuring savings. 

Our work provides two other examples of how restructuring activities
influenced the costs of major weapon systems without directly
affecting budgetary requirements.  For example, following the
Northrop Grumman business combination, several restructuring
activities, including closing Grumman's former headquarters in
Bethpage, New York, were undertaken.  Consequently, the amount of
corporate overhead costs allocated to Northrop Grumman's business
units, including the B-2 program, was less than projected before the
business combination.  B-2 program officials told us that no
adjustments were made to the B-2 program's estimated costs or future
budget requests due to restructuring. 

According to these officials, projected savings from the combination
may have been reflected in new overhead rates, which would then be
used in preparing new contract proposals or finalizing overhead rates
on existing flexibly priced contracts.  In fact, the B-2's general
and administrative overhead rate·to which corporate overhead costs
are allocated·actually rose significantly from 1993 to 1996, due
principally to the decrease in the planned procurement of B-2s. 
Consequently, while the lower corporate overhead costs resulted in
the B-2's general and administrative overhead rate being slightly
lower than it would have been without the restructuring, the changes
in planned procurement more than offset the impact of restructuring. 

Similarly, the Air Force's Titan IV launch vehicle program was
affected by the Martin Marietta- General Dynamics and Lockheed-Martin
Marietta business combinations.  According to Lockheed Martin,
restructuring activities resulted in a benefit of over $600 million
to the Titan IV program.  Titan IV program officials agreed that
restructuring activities reduced projected program costs, but
indicated that it was not possible to precisely quantify the impact
of restructuring.  These officials explained that a number of changes
were occurring concurrently on the Titan program, including a
reduction in the number of launch vehicles and the implementation of
various acquisition reform initiatives.\8 Nevertheless, program
officials told us that restructuring activities contributed to their
ability to absorb congressional, DOD, or Air Force budget cuts or to
fund other program-related needs. 


--------------------
\7 The actual figure for DOD's share of net savings is slightly
higher than the figure reflected above, principally because
restructuring costs are generally amortized.  Consequently, while
certified savings are to be realized between 1993 and 2000, DOD will
incur restructuring costs through 2004. 

\8 We reported on the effects that acquisition reform initiatives had
on weapon system funding in our report, Acquisition Reform:  Effect
on Weapon System Funding (GAO/NSIAD-98-31, Oct.  29, 1997).  We
reported that the Titan IV's estimated cost, measured in terms of
changes to its December 1993 and December 1995 selected acquisition
reports, fell from $37.7 billion to $23.6 billion.  DOD attributed
$661.8 million of this reduction to acquisition reform initiatives. 


   RECOMMENDATION
------------------------------------------------------------ Letter :8

Our work indicates that DCAA's guidance does not provide sufficient
criteria to evaluate restructuring savings, particularly savings that
may have been achievable without restructuring.  Estimates based on
this guidance may not accurately depict the savings associated with
restructuring.  Consequently, we recommend that the Secretary of
Defense direct the Director, DCAA, to clarify DCAA's guidance on
evaluating restructuring savings.  In particular, the guidance should
discuss how to evaluate proposed savings based on activities that
were ongoing or planned prior to restructuring or that could have
been achieved absent restructuring, such as those achievable by
management improvements. 


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

DOD commented on a draft of the proprietary report.  DOD disagreed
with our finding that some of the savings it reports may not be
directly attributable to restructuring.  DOD also disagreed with our
recommendation that DCAA's guidance needs to be clarified.  DOD
believed DCAA's current guidance properly implements the legislative
requirements.  DOD indicated that in reviewing restructuring
proposals, it is most concerned with ensuring both that savings
exceed costs by the required ratio and that restructuring costs and
savings are factored into contract pricing mechanisms as quickly as
possible.  DOD further noted that when a contractor can demonstrate
that savings will significantly exceed costs, there is usually no
reason to argue over whether the savings could have been accomplished
without restructuring. 

We agree with DOD that it has established a process to comply with
the legislative intent that DOD's share of projected savings exceeds
its projected share of costs, and strongly agree that DOD should
ensure that the impact of restructuring is factored into contract
pricing mechanisms as quickly as possible.  We also believe DCAA's
guidance provides an overall framework to evaluate savings.  For
example, the guidance states contractor restructuring efforts are
intended to result in the combinations of facilities, operations, or
workforce that eliminate redundant capabilities, improve future
operations, and reduce overall costs.  The guidance further states
that auditors should ensure that future savings are reasonable and
not due to other factors, such as changes in inflation or interest
rates. 

Nevertheless, our work indicates that this broad framework may result
in DOD accepting savings that may not be directly attributable to
restructuring.  At one location at which a considerable amount of
savings were proposed due to the adoption of improved business
practices, contractor officials acknowledged that some of the
improvements and associated savings could have been implemented
without restructuring, noting that the contractor had various efforts
to improve its operational efficiency underway or planned prior to
restructuring.  DCAA officials indicated that DCAA's guidance does
not provide sufficient criteria to allow them to question such
savings. 

Ensuring that such savings are related to restructuring would seem a
basic element necessary to satisfy the legislative criteria and
DCAA's own guidance.  Further, DOD reports annually to Congress on
the net savings expected from combinations certified during the
preceding year, as well as estimates of savings actually realized. 
While making such estimates is inherently difficult, the reports
should, in our view, attempt to accurately depict the impact of
restructuring to the extent possible.  Finally, several business
combinations have recently announced their intent to restructure,
including Raytheon and Boeing.  Our discussions with DCAA, Defense
Contract Management Command (DCMC), and contractor officials
indicated that better guidance as to what constitutes
restructuring-related savings would assist in these efforts. 
Consequently, we believe augmenting the existing criteria with a
discussion of the various factors that auditors should consider in
evaluating savings is a reasonable request. 

DOD's comments are reprinted in appendix I. 


   SCOPE AND METHODOLOGY
----------------------------------------------------------- Letter :10

To determine the amount and nature of restructuring costs, we
requested the cognizant DCMC office to provide updated
restructuring-related cost and savings information for each of the
business combinations in our review.  We analyzed this information to
determine the amount of restructuring costs incurred for workforce
reductions and to identify the costs associated with services
provided to assist laid-off workers find reemployment.  We did not,
however, independently verify the information provided. 

In assessing restructuring savings relative to the restructuring
costs paid by DOD, we relied on the information contained in DOD's
November 22, 1997, report to Congress.  We did examine, however, the
methodology DCAA used to estimate the amount of restructuring costs
paid by DOD and the amount of estimated savings at selected units of
business combinations at which we conducted work. 

To determine the budgetary implications of restructuring savings, we
compared DOD's share of certified restructuring savings to DOD's
actual or projected budgets for the period over which the savings
were expected to be realized.  We discussed how DOD uses projected
restructuring savings in formulating its budget requests with
officials from the Office of the Under Secretary of Defense
(Comptroller/Chief Financial Officer).  We also discussed how
projected restructuring savings were used by the Air Force's Titan IV
and B-2 program offices in formulating their budget requests. 

Finally, we discussed various aspects of the restructuring costs and
savings with officials from the business combinations, DOD, DCMC, and
DCAA. 

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


--------------------------------------------------------- Letter :10.1

We are sending copies of this report to appropriate congressional
committees; the Secretary of Defense; the Commander, DCMC; and the
Director, DCAA.  We will also provide copies to other committees and
Members of Congress upon request. 

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

David E.  Cooper
Associate Director
Defense Acquisitions Issues




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



(See figure in printed edition.)



(See figure in printed edition.)



(See figure in printed edition.)


The following are our comments on the Department of Defense's (DOD)
letter dated March 26, 1998: 

GAO COMMENTS

1.  Questions regarding the treatment of proposed restructuring
savings have arisen during other certifications.  We illustrated it
at one business segment because of the large amount of savings there
and the concerns expressed by the Defense Contract Audit Agency
(DCAA), Defense Contract Management Command (DCMC), and contractor
officials regarding the need for additional guidance.  However, we
did not intend to imply that certification of the overall business
combination·which had to demonstrate only that DOD's share of
projected savings exceeded its projected share of costs·was improper. 

It should be noted that the issue as to what constitutes
restructuring-
related savings is not limited to the certification process, but also
plays a role in DOD's report to Congress on realized savings.  For
example, based in part on our work at this business segment, DCAA
officials rejected $66 million in savings the contractor claimed on
one program.  While DCAA rejected more than $124 million overall at
this location, DCAA officials told us the absence of clear criteria
precluded them from questioning additional amounts of the claimed
savings. 

2.  We would agree that any costs associated with activities that are
not directly related to restructuring should not be subject to the
certification process, but rather should be reviewed under normal
auditing practices.  As with savings, eliminating costs that are not
restructuring-related would provide a more accurate depiction of
restructuring activities. 

3.  We did not intend to suggest that DOD should adopt the joint
guidance issued by the Department of Justice and the Federal Trade
Commission per se, but rather we used the joint guidance to
illustrate an approach that DCAA should consider in revising its
guidance.  We have revised the text accordingly. 


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
John D.  Heere

ATLANTA FIELD OFFICE

George C.  Burdette
Erin B.  Baker
Beverly A.  Breen

LOS ANGELES FIELD OFFICE

Dorian R.  Dunbar
Kenneth H.  Roberts
Thaddeus S.  Rytel, Jr. 

SAN FRANCISCO FIELD OFFICE

Ruth-Ann Hijazi
Donald Y.  Yamada


*** End of document. ***