United States General Accounting Office

GAO Report to Congressional Committees

December 1998 DEFENSE INDUSTRY

Restructuring Costs

Paid, Savings Realized,

and Means to Ensure

Benefits

GAO/NSIAD-99-22

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-280962 

December 1, 1998

Congressional Committees

Section 804 of the National Defense Authorization Act for Fiscal Year 19981

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

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.

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B-280962 

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.

Results in Brief 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 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.

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.

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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.

Restructuring Savings

and Costs

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

Business combination

Total

savings

Total

costs

Net

savings

Hughes - General Dynamics missile operationsa $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

Systems Division

139.6 50.7 88.9

Northrop - Grumman - Vought 263.4 46.7 216.7

Lockheed - Martin Marietta 2,675.8 405.9 2,269.9

Hughes - CAE-Link 148.1 35.0 113.1

Total $4,117.8 $856.2 $3,261.6

aWith 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.

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B-280962 

We reported in September 19984 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 report5

 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

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).

Page 4 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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

Business combination

Savings

realized

Costs

paid

Net

savings

Hughes - General Dynamics missile operationsa $505.8 $121.4 $384.4

UDLPa 37.6 14.0 23.6

Martin Marietta - General Electric Aerospacea 198.2 71.9 126.3

Martin Marietta - General Dynamics Space

Systems Divisiona

163.7 26.4 137.3

Northrop - Grumman - Voughtb 113.0 17.5 95.5

Lockheed - Martin Mariettab 1,406.6 49.7 1,356.9

Hughes - CAE-Linkb 37.3 13.8 23.5

Total $2,462.2 $314.7 $2,147.5

aAs of August 31, 1997.

bAs 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.

Methodology for

Determining Savings

on Specific Contracts

Not Feasible

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

Page 5 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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

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 rates6

 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,

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.

Page 6 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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 19987

 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

7

Defense Contractor Restructuring: DOD Risks Forfeiting Savings on Fixed-Price Contracts

(GAO/NSIAD-98-162, July 17, 1998).

Page 7 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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.

Conclusions 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 DOD concurred with the report’s findings. DOD’s comments are included as

appendix I.

Scope and

Methodology

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

Page 8 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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.

Page 9 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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

Page 10 GAO/NSIAD-99-22 Restructuring Costs and Savings
B-280962 

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

Page 11 GAO/NSIAD-99-22 Restructuring Costs and Savings
Contents

Letter 1

Appendix I 

Comments From the

Department of

Defense

14

Appendix II 

Major Contributors to

This Report

16

Related GAO Products 20

Tables Table 1: DOD’s Projected Restructuring Savings and Costs 3

Table 2: DOD’s Estimate of Restructuring Savings Realized and

Costs Paid

5

Abbreviations

DCAA Defense Contract Audit Agency

DCMC Defense Contract Management Command

DOD Department of Defense

UDLP United Defense Limited Partnership

Page 12 GAO/NSIAD-99-22 Restructuring Costs and Savings
Page 13 GAO/NSIAD-99-22 Restructuring Costs and Savings
Appendix I 

Comments From the Department of Defense

Page 14 GAO/NSIAD-99-22 Restructuring Costs and Savings
Appendix I 

Comments From the Department of Defense

Page 15 GAO/NSIAD-99-22 Restructuring Costs and Savings
Appendix II 

Major Contributors to This Report

National Security and

International Affairs

Division, Washington,

D.C.

John K. Harper

Timothy J. DiNapoli

Paula J. Haurilesko

Atlanta Field Office George C. Burdette

Page 16 GAO/NSIAD-99-22 Restructuring Costs and Savings
Page 17 GAO/NSIAD-99-22 Restructuring Costs and Savings
Page 18 GAO/NSIAD-99-22 Restructuring Costs and Savings
Page 19 GAO/NSIAD-99-22 Restructuring Costs and Savings
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).

(707382) Page 20 GAO/NSIAD-99-22 Restructuring Costs and Savings
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