BUDGETARY COST SAVINGS

TO THE DEPARTMENT OF DEFENSE

RESULTING FROM FOREIGN MILITARY SALES

Staff Working Paper

May 24, 1976

CONGRESSIONAL BUDGET OFFICE

U.S. CONGRESS

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Budgetry cost Savings to the Department of Defense Resulting from

Foreign Military Sales

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PREFACE

This paper was written in response to a request from the House

Armed Services Committee for an analysis of the effect of changes in

U.S. policies regarding arms sales abroad. Specifically, the paper

examines and projects the cost savings from the foreign military sales

program on the basis of data analysis of 35 weapon systems.

This report was prepared by James R. Capra, Robert E. Schafer, and

Patrick L. Renehan of the Budget Analysis Division of the Congressional

Budget Office. The authors would like to acknowledge the assistance of

Terry Nelson and Ramon Espinosa of the Budget Analysis Division and

Sheila Kean Fifer of the National Security Division.

A related CBO staff working paper, Foreign Military Sales and U.S.

Weapons Costs, examines the circumstances in which budgetary savings

result from the foreign military sales program.

Alice M. Rivlin

Director

(in)
CONTENT S

Page

Preface iii

Summary ix

Introduction 1

Categories of savings 3

Research and development recoupment 3

Learning curve effects and economies of scale 3

Overhead 4

Production line gap 5

Other 5

Savings estimates for 35 major weapons systems 7

Past and projected savings 7

Quality of estimates 7

Characteristics of estimates 12

Sales which are likely to generate savings 13

Sales by weapons category 13

Composition of foreign military sales 15

Estimation of dollar value of savings 17

The percentage of sales which can generate savings 17

Savings per dollar of sales for sales which generate savings 17

Savings under current and reduced programs 18

The effect of a ban or reduction of foreign military sales 21

Appendix A 23

( V)
TABLES

1. Past savings, fiscal years 1972-76 8

2. Estimated future savings, fiscal years 1977-81 9

3. Estimated total savings and sales, fiscal years 1972-81 10

4. Savings and sales in current and constant dollars, fiscal years 1972-81. 11

5. Foreign military sales by sales categories 16

6. Savings per dollar of sales for sales which generate savings 18

7. Average savings per dollar of sales for foreign military sales program 22

8. Total savings 22

9. E. & D. savings 22

A. Alternative estimates of average savings-sales ratio 26

(VII)
SUMMARY

One of the elements of current debate on U.S. policies regarding

the sale of arms abroad has been the economic consequences of significant changes in the foreign military sales (FMS) program. Assessment of

these consequences centers on two issues: the budgetary cost savings to

the U.S. which result from foreign military sales and the macroeconomic

effects of such sales. This study addresses the first of these issues,

the budgetary cost savings. A later analysis will focus on the macroeconomic effects of foreign military sales.

This study quantifies the budgetary cost savings attributable to

foreign military sales and estimates the dollar value of savings associated with an $8 billion sales program under certain assumptions about

the mix of sales among the categories of weapons, services, and construction. The results are based on analysis of data from sales of 35 major

weapon systems.

Among the findings of the study are the following:

t An $8 billion sales program will, on the average, generate

$560 million in cost savings annually. This estimate

assumes the current mix of sales of weapons, services, and

construction. The estimate also assumes that the U.S. would

not significantly alter the defense production base in the

absence of foreign military sales,

• Of the $560 million in savings, approximately $160 million

represents savings which are attributable to research and

development (R&D) recoupments, a category of savings which

is insensitive to assumptions about the U.S. production base

and the pace of U.S. procurement in the absence of foreign

military sales.

t Assuming the current mix of sales, a decrease in the level

of sales from the $8 billion level would result in a proportional decrease in the savings. For example, a $4 billion

sales program would on the average result in savings of

$280 million annually.

The analysis in this study begins by classifying savings into five

major categories: R&D recoupments, learning curve effects and economies

of scale, overhead, production line gap, and other. R&D recoupments

refer to the R&D surcharge which is added to the purchase price of a

i (IX)
weapon system sold to a foreign buyer in order to recoup some of the

resources which the U.S. put into the development of the weapon. Savings from learning curb effects are those savings which result from

the lower average costs associated with a longer production run, while

economies of scale refer to the lower average costs due to a larger rate

of production. Overhead savings refer to the fact that foreign buyers

may partially pay for indirect costs, such as facilities costs, that

would have otherwise been borne solely by the U.S. Government. Savings

from avoiding production line gaps occur when a foreign sale allows a

contractor to keep a production line open for a subsequent U.S. buy,

thus enabling the U.S. to avoid production line termination and setup

costs. Other savings is a residual category for those savings which do

not fall in the first four categories.

The study contains estimates of savings for 35 major weapon systems

due to foreign military sales over the 1972-1981 time period. These

savings are partitioned into the five major categories of savings. The

estimates show that the most significant savings are due to R&D recoupment and overhead savings.

The study notes that not all foreign military sales result in cost

savings. For example, sales of training or other types of services do

not in general result in cost savings to the U.S. For the current mix

of sales the study estimates that only fifty percent of foreign military

sales result in cost savings to the U.S. For those sales which can

generate savings, the study estimates that on the average one dollar of

sales results in fourteen cents in savings to the U.S., of which four

cents represent R&D recoupments. These estimates are based on analysis

of the data for the 35 major weapon systems.

The study concludes with estimates of savings under alternative

levels and alternative mixes of foreign military sales.

(X)
INTRODUCTION

This is a report on the financial aspects of the sale of U.S. arms

abroad. Specifically, this report deals with the budgetary cost savings

to the U.S. Department of Defense which are generated by foreign military

sales. Based on the current mix of sales of weapons, services, and construction, an $8 billion sales program would on the average generate

$560 million in savings annually. This estimate of savings presumes then

the U.S. would not significantly alter the defense production base in the

absence of foreign military sales. If only research and development

(R&D) savings are considered, an $8 billion sales program would on the

average generate $160 million in R&D recoupments. If the mix of sales

were to remain the same but the foreign military sales program were

reduced, the savings would be reduced proportionally. For example, a

$4 billion program would on the average generate $280 million in total

savings of which $80 million represents R&D recoupments.

The report first discusses the types of savings which can be generated and classifies savings into five groups or categories. Next, data

on past and projected savings for 35 selected weapon systems are presented. This is followed by a discussion of what kinds of foreign military sales for fiscal year 1975 had the potential to generate savings.

Finally, an estimate is made of the dollar value of savings for an

$8 billion sales program based on data for 35 major weapon systems and

on two alternative mixes of sales.

This paper focuses on government-to-government arms sales and for

the most part does not discuss commercial sales. 'As will become clear

upon discussion of the types of budgetary savings which can be generated

by foreign military sales, commercial arms sales have little potential

for generating budgetary savings to the Department of Defense.

This report does not address the questions of whether foreign arms

sales further U.S. security interests nor does it discuss the macroeconomic, effect of foreign military sales. This latter subject will be

the topic of a later report.

(i)
CATEGORIES OF SAVINGS

The savings generated by foreign military sales can be classified

into five major categories. Following is a brief definition and characterization of each category. A more detailed discussion of these categories, especially research and development (R&D) recoupments and "learncurve effects," leading to lower unit costs, can be found in CBO staff

working paper, Foreign Military Sales and U. S. Weapons Costs.

Research and Development Recoupment

The first and most readily identifiable saving from foreign military

sales is R&D recoupment. R&D recoupment refers to the R&D surcharge

which is added to the purchase price of a weapon system sold to a foreign

buyer. This surcharge represents R&D expenses which would otherwise have

been borne by the U.S. alone, and consequently would appear to be a clear

cut example of a cost saving. The magnitude of R&D recoupment varies, of

course, with the weapon systemJ

Learning Curve Effects and Economies of Scale

Savings from learning curve effects refer to those savings which

result from a longer production run for weapon systems, especially aircraft and missiles. As described in "Military Equipment Cost Analysis,"

it is a relatively well-documented fact that in the absence of other

factors the cumulative average cost of aircraft and missiles decreases as

the total number produced increases. Factors which are frequently

mentioned as being responsible for this decreasing average cost are job

familiarization by workmen, general improvement in total coordination,

and development of more efficiently produced subassemblies. If the sale

of arms to a foreign country makes it possible for some of the items

produced for the U.S. to be purchased at a lower average cost due to

learning curve effects, then the foreign sale in fact produces cost

savings.

1. For a detailed discussion of the guidelines for setting the size of

the R&D surcharge, see: CBO staff working paper, Foreign Military Sales

and U.S. Weapons Costs (May 1, 1976), p. 7; and DoD Directive 5105.38

(Aug. 11, 1971: amended May 10, 1973).

2. Rand Corporation, Military Equipment Cost Analysis (Santa Monica,

Calif.: Rand Corporation, June 1971).

i

i (3)
Economies of scale refer to the economic principle which states that,

under some circumstances, expanding the rate of production (for example,

fully utilizing an existing production facility) can result in lower

average costs. Again, if a foreign sale enables U.S. weapons to be purchased at a lower average cost, then the foreign sale can be said to

generate cost savings.

Despite the general agreement among analysts that learning curve

effects and economies of scale can generate cost savings, such savings

are relatively difficult to estimate since accounting records do not

facilitate isolation of these savings from other savings, such as overhead savings.

Overhead

Another source of potential cost savings is related to overhead

costs. In general, not all of the costs which are charged to a contractor for a-weapon system are attributable to the materials and labor which

are going into that weapon system. The contractor also bears certain

indirect costs that are passed on to his customers. To the extent that

foreign buyers pay for indirect costs that would have otherwise been

borne by the U.S. Government, foreign military sales generate overhead

savings.

Overhead costs can be classified in many ways. One particularly

useful classification is that between fixed and variable overhead costs.

Fixed overhead costs are costs which do not vary with the number of goods

produced; that is, they are costs which are relatively insensitive to

changes in the volume of sales. The costs of facilities or of a fixed

staff of design engineers are examples. Variable overhead costs are

those which do vary with the volume of sales. To the extent that the

costs of facilities or the size of the staff of design engineers vary

with the volume of sales, these costs can be said to be variable.

Foreign military sales generate overhead cost savings when they

make it possible for fixed overhead charges to be paid partially by

foreign buyers rather than solely by the U.S. Government. Unfortunately,

these savings are relatively difficult to estimate. An upper bound on

such savings would be the amount of overhead costs paid by foreign buyers.

However, it should be noted that, to the extent that these overhead costs

are not fixed or would be borne by other than U.S. Government business

(e.g., private buyers such as commercial airlines), they do not represent

savings which are the result of foreign military sales.

The attribution of significant overhead savings to foreign military

sales assumes that in the absence of foreign sales the U.S. would not

significantly change its production base. A rationale for this is the

argument that the U.S. production base is sized to meet emergency requirements and would not be reduced in peacetime in the absence of foreign
military sales.

The sharing of overhead costs is one savings which could theoretically result from a commercial foreign military sale as well as a

government-to-government sale. For example, if a foreign country is buying equipment directly from a contractor and the contractor is simultaneously producing a weapon system for the U.S., then the commercial sale

may result in the U.S. having to pay lower overhead costs than would have

otherwise have been the case. It does not appear at first glance that

commercial sales very often result in savings of this type. The only

example identified to date is the C-130 aircraft.

Production Line Gap

The next major category of cost savings which may result from

foreign military sales is associated with the closing and opening of

production lines with concomitant setup and termination costs. If a

foreign sale allows a contractor to keep a production line open for a

subsequent U.S. buy, then it would appear that the foreign sale generates

some cost savings. Like other savings, those associated with avoiding

gaps in production lines are difficult to validate. A major difficulty

is that they depend on a comparison of current, proposed, and hypothetical

production plans. For example, it is clearly not the case that every

time a foreign sale occurs in the middle of two production runs for the

U.S., the U.S. would have incurred costs for a production line gap were

it not for the foreign sale. In certain instances, the U.S. would most

likely have merged the two production runs into one were it not for the

foreign buy.

Other

There are other savings which may result from foreign military sales.

Most of these fall into the category of nonrecurring costs which the U.S.

Government is able to share with foreign buyers. For example, suppose

the U.S. wants to expand or accelerate the production of tanks from

thirty to forty per month. Also, suppose the acceleration causes the

opening of a new production line capable of producing an additional

thirty tanks per month. Setting up a new production line involves certain nonrecurring costs for tooling and so forth. If a foreign buyer

decides to purchase twenty tanks per month and assumes a prorata share of

the nonrecurring costs of setting up the new production line, then the

foreign sale generates savings.
SAVINGS ESTIMATES FOR 35 MAJOR WEAPON SYSTEMS

The Department of Defense has provided estimates of savings generated by foreign military sales for 35 major weapon systems. The savings,

calculated in current dollars, are for past sales, in the fiscal years

1972-76 period, and future sales, in the fiscal years 1977-81 period.

Tables 1 through 3 contain DoD's estimates of savings according to the

categories of R&D recoupment, learning curve, overhead, production line

gap and other. Table 3 also contains estimates of dollar value of the

sales which generated or will generate the savings.

Past and Projected Savings

The savings listed in tables! through 3 are aggregate numbers and

are not in constant dollars. This means that the effect of inflation on

the estimates is indeterminate. In order to account for the effects of

inflation it is necessary to break out savings by year. DoD was unable

to provide a yearly listing of savings for each of the systems listed in

tables 1 through 3. After negotiation between representatives of the DoD

and the Congressional Budget Office, DoD agreed to provide a yearly listing of savings for five selected weapon systems. These listings, in

current and constant dollars, are contained in table 4.

Quality of Estimates

The estimates of savings and sales in tables 1 through 3 were made

by the Army, Navy, and Air Force. Although time and resources did not

permit a detailed validation of all the services' estimates, CBO staff

held extensive discussions with personnel responsible for the estimates

for six of the systems: the M60 tank, the TOW missile system, the H-l

helicopter series, the HARPOON missile,the F-4E aircraft, and the F-16

aircraft. These discussions focused on the methodology used for estimating both cost savings and sales. In the case of the Army systems, field

personnel provided extensive backup for the estimates. In the view of

the CBO staff involved, the savings and sales estimates for the six

systems are reasonable, given the time and resources available. Although

the remaining systems were not investigated in detail, service personnel

were asked general questions on the estimates. There is no evidence that

the methodology used to compute savings and sales for the remaining

systems differed in substance from that used on the six selected systems.
TABLE 1. PAST SAVINGS FISCAL YEARS 1972-76

(Millions of Current Dollars)

M60A1, Combat Tank

M72B, Combat Engineer Vehicle

M60A1, Tank Chassis for AVLB

Launcher

AVLB Launcher

AVL Bridge

M113A1 ARC - Family roll-up

SP8" MHO Howitzer

M578 Recovery Vehicle

SP 155MM,M109A1B Howitzer

M88A1 Recovery Vehicle

AA,SP,M163 (VULC) Gun

HI Helicopter Series

Dragon

Tow

Chapparal Launcher

Chapparal (GM)

Hawk Missile System

Lance Missile System

Phoenix

Sidewinder (AIM-9L)

P-3

S-3A

E-2C

F-14

A-7

Harpoon

F-15

F-16

F-5E/F

AWACS

AIM-9B Mod. to AIM-9S

Maverick

F-4E

Pave Spike

EOGB II

Total

Savings

124.1

1.1

2.0

0.2

0.1

27.4

14.5

5.8

16.5

0.0

5.8

36.4

0.0

89.6

0.0

0.0

25.3

10.0

19.1

0.0

1.2

0.0

0.0

229.2

1.5

22.0

0.0

0.0

40.0

0.0

0.0

5.6

299.4

0.0

5.9

Research and

Development

1.9

0.0

0.1

0.0

0.0

0.0

0.7

0.6

1.4

0.0

0.0

4.9

0.0

25.5

0.0

0.0

8.3

4.0

15.5

0.0

1.2

0.0

0.0

168.6

0.2

3.4

0.0

0.0

18.8

0.0

0.0

5.6

25.4

0,0

0.0

Learning

Curve

0,0

0.0

0.0

0.0

0.0

7.7

5.4

4.2

0.0

0.0

0.0

0.3

0.0

21.8

0.0

0.0

5.7

0.0

1.2

0.0

0.0

0.0

0.0

20.6

1.3

4.6

0.0

0.0

8.0

0.0

0.0

0.0

1.2

0.0

0.5

Overhead

59.5

0.7

1.5

0.0

0.0

15.6

6.7

0.5

13.6

0.0

5.3

31.3

0.0

5.7

0.0

0.0

11.3

0.0

0.3

0.0

0.0

0.0

0.0

40.1

0.0

10.2

6.0

0.0

9.6

0,0

0.0

0.0

263.8

0,0

0.0

Production

Line Gap

0.0

0.0

0.0

0.0

0.0

2.5

1.6

0.6

1.5

0.0

0.5

0.0

0.0

0.0

0.0

0.0

0.0

6.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

o.o0.0

0.0

0.0

0.0

0.0

0.0

9.0

0.0

0.0

Other

62.7

0.4

0.4

0.1

0.1

1.6

0.0

0.0

0.0

0.0

0.0

0.0

0.0

36.6

0.0

0.0

0.0

0.0

2.1

0.0

0.0

0.0

0.0

0.0

0.0

3.8

0.0

0.0

3.6

0.0

0.0

0.0

0.0

0.0

5.4

oo

Source: Department of Defense
TABLE 2. ESTIMATED FUTURE SAVINGS FISCAL YEARS 1977-81

(Millions of current dollars)

Total

System Savings

M60A1, Combat Tank 335.7

M72B, Combat Engineer Vehicle 11.4

M60A1, Tank Chassis for AVLB 7.2

Launcher

AVLB Launcher 0.3

AVL Bridge 0.4

M113A1 APC - Family roll-up 91.

SP8" MHO Howitzer 0.

M578 Recovery Vehicle 5.

SP 155MM,M109A1B Howitzer 53.

M88A1 Recovery Vehicle 5.7

AA,SP,M163 (VULC) Gun 17.9

HI Helicopter Series 27.1

Dragon 40.7

Tow 75.9

Chapparal Launcher 17.0

Chapparal (GM) 11.6

Hawk Missile System 63.5

Lance Missile System 60.0

Phoenix 13.5

Sidewinder (AIM-9L) 6.1

P-3 6.8

S-3A 13.5

E-2C 16.6

F-14 0.0

A-7 4.1

Harpoon 94.5

F-15 70.1

F-16 126.0

F-5E/F 67.0

AWACS 338.6

AIM-9B Mod. to AIM-9S 3.0

Maverick 114.8

F-4E 113.6

Pave Spike 1.0

EOGB II 1.5

Source: Department of Defense

Research and

Development

3.9

0.3

0.2

0.0

0.0

0.0

0.2

0.6

2.3

0.0

0.0

3.9

20.7

23.6

4.5

3.7

23.4

6.0

0.0

0.0

4.8

7.5

6.8

0.0

0.5

49.7

40.0

67.7

23.0

219.8

0.4

17.2

10.8

1.0

.7

Learning

Curve

0.0

0.0

0.0

0.0

0.0

26.9

0.0

1.7

5.9

0.0

0.0

0.7

17.5

31.4

8.6

2.7

9.5

0.0

4.5

6.1

0.0

0.0

0.0

0.0

3.6

20.0

30.1

43.7

11.6

118.8

0.0

58.5

0.0

0.0

0.0

Overhead

216.2

7.2

5.8

0.0

0.0

54.7

0.0

2.8

37.3

5.7

15.1

19.0

2,5

8.0

1.6

1.5

30.6

0.0

1.2

0.0

2.0

2.0

9.8

0.0

0.0

10.3

0.0

14.6

24.9

0.0

0.0

0.0

102.8

0.0

0.0

Production

Line Gap

0.0

0.0

0.0

0.0

0,0

9.5

0.0

0.0

8.4

0,0

2,8

3.5

0.0

5.0

2.3

3.7

0.0

54.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

34.1

0.0

0.0

0.0

Other

115.6

3.9

1.3

0.3

0.4

0,2

0,0

0.0

0,0

0.0

0.0

0.0

0.0

7.9

0.0

0.0

0.0

0.0

7.8

0.0

0.0

4.0

0.0

0.0

0.0

14.5

0.0

0.0

7.5

0.0

2.6

5.0

0.0

0.0

0.7
TABLE 3. ESTIMATED TOTAL SAVINGS AND SALES FISCAL YEARS 1972-81

(Millions of Current Dollars)

M60A1, Combat Tank

M72B, Combat Engineer Vehicle

M60A1, Tank Chassis for AVLB

Launcher

AVLB Launcher

AVL Bridge

M113A1 ARC - Family roll-up

SP8" MHO Howitzer

M578 Recovery Vehicle

SP 155MM, M109A1B Howitzer

M88A1 Recovery Vehicle

AA,SP,M163 (VULC) Gun

HI Helicopter Series

Dragon

Tow

Chapparal Launcher

Chapparal (GM)

Hawk Missile System

Lance Missile System

Phoenix

Sidewinder (AIM-9L)

P-3

S-3A

E-2C

F-14

A-7

Harpoon

F-15

F-16

F-5E/F

AWACS

AIM-9B Mod. to AIM-9S

Maverick

F-4E

Pave Spike

EOGB II

Total

Sales

1,232.7

26.9

46.9

53.1

10.5

1,346.2

21.8

50.9

241.1

84.9

205.8

601.0

291.0

670.7

133.0

58.0

181.1

297.0

193.0

34.1

249.1

350.0

111.1

1,412.2

206.3

395.4

240.0

885.6

1,683.6

3,476.0

8.8

241.5

2,142.0

20.0

14.3

Total

Savings

459.8

12.4

9.2

0.4

0.5

118.7

14.7

10.8

70.4

5.7

23.7

63.5

40.7

165.5

17.0

11.6

88.8

70.0

32.6

6.1

8.0

13.5

16.6

229.2

5.6

116.5

70.1

126.0

107.0

338.6

3.0

120.4

413.0

1.0

7.4

Research and

Development

5,8

0,3

0,3

0.0

0,0

0.0

0.8

1,1

3,7

0.0

0.0

8,8

20.7

49.1

4.5

3.7

31,7

10.0

15.5

0,0

6.0

7.5

6.8

168.6

0,7

53.1

40.0

67.7

41.8

219.8

0.4

22.8

36.2

1.0

0.0

Learning

Curve

0.0

0.0

0.0

0.0

0,0

34.6

5,4

5,9

5.9

0,0

0,0

1,0

17,5

53,2

8,6

2,7

15,2

0,0

5.7

6,1

0,0

0,0

0.0

20.6

4.9

24.6

30,1

43.7

19.6

118.8

0.0

58.5

1.2

0.0

1.3

Overhead

275.7

7.9

7.3

0,0

0.0

,3

.7

70,

6.

3.3

50.9

5.7

20.

50,

2.5

13,

1 ,

1,

41.

0.0

1.5

0.0

2.0

2.0

9.8

40.1

0.0

20.5

0.0

14.6

34.5

0.0

0.0

0.0

366.6

0.0

0.0

Production

Line Gap

0.0

0.0

0.0

0.0

0.0

12.0

1.6

0.6

9.8

0.0

3.3

3.5

0.0

5.0

2.3

3,7

0,0

60.0

0.0

0,0

0.0

0,0

0,0

0,0

0.0

0.0

0.0

0.0

0.0

0.0

0.0

34.1

9.0

0.0

0.0

Other

178.3

4.2

1.7

0.4

0.5

1.8

0.0

0.0

0.0

0.0

0.0

0.0

0.0

44.5

0.0

0.0

0.0

0.0

9.9

0.0

0.0

4.0

0.0

0,0

0,0

18.3

0.0

0.0

11.1

0.0

2.6

5.0

0.0

0.0

6.2

Source: Department of Defense
TABLE 4

SAVINGS AND SALES IN CURRENT AND CONSTANT DOLLARS FISCAL YEARS 1972-81

(Millions of dollars)

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 Total

M60 TANK

Savings (current)

(constant)

Sales (current)

(constant)

M113A1APC

Savings (current)

(constant)

Sales (current)

(constant)

HARPOON

Savings (current)

(constant)

Sales (current)

(constant)

£11

Savings (current)

(constant)

Sales (current)

(constant)

MAVERICK

Savings (current)

(constant)

Sales (current)

(constant)

16.1

24.6

40.8

62.3

10.8

16.4

48.1

73.4

0

0

0

0

0

0

0

0

0

0

0

0

22.5

32.8

50.0

72.9

6.6

9.6

37.9

55.2

0

0

0

0

0

0

0

0

0

0

0

0

3.1

4.2

8.5

11.4

5.6

7.5

375.3

505.1

0

0

0

0

168.6

226.9

1,412.2

1,900.7

0

0

0

0

5.9

6.8

13.7

15.9

1.1

1.3

81.8

94.7

0

0

0

0

22.8

26.4

0

0

5.6

6.5

69.5

80.4

106.6

115.7

213.6

231.9

.8

.9

333.2

361.8

22.0 .

23.9

86.2

93.6

38.0

41.3

0

0

13.0

14.1

4.3

4.7

68.7

68.7

212.6

212.6

9.7

9.7

141.6

141.6

27.0

27.0

109.4

109.4

0

0

0

0

37.4

37.4

83.6

83.6

65.8

62.0

186.3

175.6

14.6

13.8

253.0

238.5

20.1

18.9

60.2

56.7

0

0

0

0

29.0

27.3

84.1

79.3

60.6

54.3

174.3

156.0

16.9

15.1

75.0

67.1

15.1

13.5

39.2

35.1

0

0

0

0

20.5

18.4

0

0

56.6

48.6

167.9

144.1

16.6

14.2

0

0

14.1

12.1

37.1

31.8

0

0

0

0

10.1

8.7

0

0

53.9

44.5

165.0

136.4

24.0

19.8

0

0

18.2

15.0

63.3

52.3

0

0

0

0

4.8

4.0

0

0

459.8

462.2

1,232.7

1,219.1

106.7

108.3

1,345.9

1,537.4

116.5

110.4

395.4

378.9

229.4

294.6

1,412.2

1,900.7

120.4

116.4

241.5

248.0

Source: Department of Defense
12

Characteristics of Estimates

The following is a discussion of some of the characteristics of

the estimates of savings and sales. In general, the estimates of R&D

savings are the most straightforward. For most systems savings were

based on a fixed charge per unit of equipment delivered. Learning curve

estimates proved to be most elusive. For-those.systems for which learning curve savings were claimed, the assumed learning curves were between

90 and 92 percent; that is, at each doubling of the production quantity,

the cumulative average cost would be 90 to 92 percent of its former value.

For one system, the TOW missile system, it is likely that estimates of

learning curve savings probably include some overhead savings. For other

systems, the opposite may be the case, with overhead including some

learning curve.

Overhead savings, together with R&D recoupments, comprise the bulk

of the savings for the 35 weapon systems. Overhead savings for the Army

appear at first glance to be relatively high. As a result, the CBO staff

asked for and received further detail on the estimate of overhead for the

M60 tank and the H-l helicopter series. In each case, the Army apportioned overhead costs among different categories, such as general administration and overhead burden, and then estimated that only a percentage

of these costs are fixed. The fixed percentage varied from 66 percent

for overhead burden to 80 percent for general administration. As discussed earlier the basic assumption underlying these savings is that in

the absence of foreign military sales the U.S. would not significantly

alter its production base.

Savings associated with gaps in the production line do not comprise

a significant part of the savings in tables 1 through 3 and consequently

were not investigated in detail.

Savings which were classified as "other" were significant for only

the M60 tank and the HARPOON missile (fiscal years 1977-81). In each

case these amounts represented one-time, nonrecurring costs for expanding

production facilities which the U.S. was able to charge foreign buyers.

It is the view of the CBO staff that these savings are more questionable

than the overhead and R&D savings since it appeared possible that expansion was to some extent to accommodate foreign military sales.

The sales estimates in table 3 reflect actual deliveries for fiscal

years 1972-76 and anticipated deliveries for fiscal years 1977-81. It

appears that the methodology used to project future sales was not consistent from system to system; however, for a given system the methodology used to project sales was consistent with that used to project savings.
SALES WHICH ARE LIKELY TO GENERATE SAVINGS

The current estimate of sales (orders) through the Foreign Military

Sales Trust Fund for fiscal year 1977 is approximately $8.2 billion.

However, not all foreign arms sales have the potential for generating

cost savings. For example, a considerable part of the dollar value of

foreign military sales represents the sale of services such as training

and repair. These sales in general do not generate R&D recoupments,

learning curve savings, overhead savings or production line gap savings.

The purpose of this section is to discuss briefly the composition of

foreign military sales, with special reference to the question of what

types of sales generate savings.

Sales by Weapons Category

Aircraft

Aircraft clearly represent one category of sales which can potentially generate cost savings. The Department of Defense has been able to

recoup R&D costs from the sale of aircraft, such as the F-14. Learning

curve effects in the aircraft industry are well-documented. To the

extent that the aircraft industry would operate at below production

capacity in the absence of foreign military sales, the sale of aircraft

has the potential for generating overhead savings. On the other hand,

it should be noted that the sale of older, well-established aircraft

types may generate significantly lower R&D recoupments. If the foreign

sale takes place at the end of a production run, it will not generate

learning curve savings. Also, if in the absence of foreign sales the

aircraft industry were able to operate at capacity by selling to private industry, the overhead savings generated by foreign sales would be

negligible.

Missiles

Missiles are very similar to aircraft in their potential to generate savings. Missiles produced in large quantities may have less potential for producing learning curve effects than aircraft unless the

foreign sale comes relatively early in the production run. On the other

hand, to the extent that missile production is a specialized industry

with little potential for sales in the private marketplace and to the

extent that the industry would operate at less than full capacity in the

absence of foreign sales, missiles have a greater potential for generating overhead savings than aircraft.

(13)
14

Tanks and Tracked Vehicles

Tables 1 through 3 provide examples of the potential savings from

the sale of tanks and tracked vehicles. Savings would generally take

the form of R&D recoupments and overhead savings. It should be noted

that the savings computed in tables 1 through 3 were based on the U.S.

procurement schedule and the existing U.S. production base. If a different production schedule or a changed production base were assumed,the

savings associated with foreign sales would change.

Communications Equipment

This category of sales includes items which range in complexity from

sophisticated electronics gear to simple radios. No data was available

on the savings associated with the sale of this type of equipment. However, it would appear that it offers the potential for at least some

overhead savings and possibly some R&D recoupments.

Other Equipment

This category of sales is not well-defined. Consequently, it is not

possible to evaluate its potential to generating savings. Insofar as the

purchase of other equipment is subject to overhead charges, foreign sales

may result in some savings.

Ships represent a category which probably offers little potential

for savings due to foreign sales. Research and development costs for

ships are not significant, at least for the types of ships which are

being sold to foreign countries.3 Learning curve effects have in general

not been observed in the shipbuilding industry, largely due to the fact

that to a very real extent each ship is unique. Overhead savings are a

theoretical possibility. However, in recent years the shipbuilding

industry has been operating at near capacity with large back orders.

This means that the elimination of foreign sales would probably not result in more overhead being charged to U.S. Navy ships on a per ship

basis.

3. R&D costs for ships would be distinguished from the R&D costs for

the weapon systems on the ships.
15

Ammunition

The sale of ammunition provides no opportunity for R&D recoupments.

Also, due to the large quantities produced, ammunition sales do not in

general lead to learning curve savings. Some overhead savings from ammunition sales are theoretically possible. However, the cases selected by

the Department of Defense to illustrate savings did not include sales of

ammunition.

Military Construction

Military construction in foreign countries is a growing part of

foreign military sales. However, it offers little prospect for savings

in U.S. military construction costs.

Services

This category of sales includes supply operations, training, repair

and rehabilitation and other services. These sales do not generate R&D

recoupments. There is no reason to expect that they would generate

learning curve savings. Although it is possible that the sale of services like repair and rehabilitation might generate some overhead savings,

DoD has provided no data on such savings and, given the magnitude of

repair and rehabilitation sales, the significance of such savings would

be limited.

Composition of Foreign Military Sales

Table 5 contains a historical breakout of foreign military sales by

the type of sales. The table shows that prior to fiscal year 1975 an

average of approximately 70 percent of foreign military sales were comprised of aircraft, missiles, vehicles and weapons and communications

equipment. As discussed earlier these are the types of sales which can

generate savings.

The mix of sales prior to fiscal year 1975 was associated with a

somewhat lower sales program than in fiscal year 1975. For example,

sales in fiscal year 1973 were approximately $3 billion compared to

$9.5 billion in fiscal year 1975. In addition, the mix of sales changed

significantly so that only approximately 50 percent of sales in fiscal

year 1975 fall into the category of sales which have the potential to

generate savings. The major factors in the changing mix of sales were

increasing sales (on a percentage basis) of ships and ammunition and

decreasing sales of aircraft.
16

Table 5

FOREIGN MILITARY SALES BY SALES CATEGORIES

 a

(Fiscal Years)

Percent of Annual Sales"

Category 1972 1973 1974 1975

Aircraft 53 53 45 27

Missiles 6 18 7 14

Vehicles & Weapons 9 13 12 7

Communications

Equipment 3 3 2 2

Subtotal 71 77 66 51

Ships 2 2 12 15

Other Equipment 5 3 4_ 7_

Subtotal 7 5 16 22

Ammunition 6 5 5 10

Construction 000 1

Repair and

Rehabilitation 410 2

Supply Operations 334 4

Training 442 3

Other Services 7 5 6 9

Subtotal 24 17 17 29

a. Weapons system sales include sales of spare parts.

b. Totals may not add due to rounding.
ESTIMATION OF THE DOLLAR VALUE OF SAVINGS

An estimate of the dollar of the savings associated with foreign

military sales is comprised -of two components. The first is an estimate

of the dollar value of sales which have the potential to generate savings.

The second is an estimate of the dollar value of savings per dollar of

sales for those sales having a potential to generate savings. The estimates given here represent long run average savings for an assumed mix

of sales. The estimates discussed in this section should be considered

to be steady state estimates in the sense that in any one year the savings could be quite different from those given here due to a different

mix of sales and the variability of savings associated with the sale of

any given item.

The Percentage of Sales Which Can Generate Savings

As discussed in the previous section, only some foreign military

sales generate cost savings to the U.S. Government. Also, over the past

few years, the mix of foreign military sales between those which do and

those which do not generate savings has changed. For the purposes of

this analysis, two alternative mixes of foreign military sales will be

assumed, roughly equivalent to the percentages which pertained from

fiscal year 1972 through fiscal year 1974 (Mix 2) and those for fiscal

year 1975 (Mix 1).

Mix 1 Mix 2

Percent Capable of Generating Savings .5 .7

Percent not Capable of Generating Savings .5 .3

Savings Per Dollar of Sales for Sales Which Generate Savings

The data from the 35 weapon systems in table 3 was analyzed in order

to estimate the savings per dollar of sales for those sales with the

potential to generate savings. As shown in table 6, the estimated average savings per dollar of sales for those sales with the potential to

generate savings is $.14. Since estimates of overhead savings and to a

lesser extent the remaining categories of savings rely on particular

assumptions about the U.S. production base and the pace of U.S. procurement, the R&D savings have been separated from the other categories of

savings. For R&D recoupments, the estimated average savings per dollar

of sales is $.04. Table 6 also contains the standard error of the

estimates.

(17)
18

TABLE 6

SAVINGS PER DOLLAR OF SALES FOR SALES

WHICH GENERATE SAVINGS9

Total Savings R&D Other Categories

Average Savings $.14 $.04 $.10

Standard Error .02 .01 .03

a. The estimates were computed using a logarithmic model of savings

and sales. See the technical appendix for details on the estimator

and on alternative estimators.
19

The estimates in table 6 were computed using the data on sales and

savings in the fiscal years 1972-81 time period. When the data are subdivided into fiscal years 1972 - 76 and fiscal years 1977 - 81, the

results for the two time periods are not significantly different in a

statistical sense and in fact are practically identical, being within

$.01 of each other for total savings and exactly equal for R&D savings.

Savings Under Current and Reduced Programs

Using the results in table 6 and the two assumed mixes of foreign

military sales it is possible to estimate the average savings per dollar

of sales for the total FMS program. Table 7 contains these estimates.

They were derived by multiplying the savings per dollar of sales for

sales which generate savings times the percentage of total sales which

generate savings. Using the current mix of sales, with approximately

50 percent of sales having the potential to generate savings, total savings per dollar of sales are $.07 and R&D savings per dollar of sales

are $.02.
THE EFFECT OF A BAN OR REDUCTION OF FOREIGN MILITARY SALES

The current level of foreign military sales is approximately $8

billion per year. Tables 8 and 9 contain estimates of total savings and

R&D savings under an $8 billion sales program, using the current mix of

sales (mix 1) and the previous mix of sales (mix 2). (As discussed

earlier, R&D savings have been broken out separately since they are relatively insensitive to particular assumptions about the U.S. production

base and the pace of U.S. procurement.) Under the current mix of sales,

total savings would on the average be $560 million annually, while R&D

savings would be $160 million per year. Tables 8 and 9 also.contain

estimates of the savings under a $4 billion sales program. It should be

noted that the estimates are averages and in any one year the savings

might be different from the estimates, depending on the mix and timing of

rates.

Using Tables 8 and 9 it is possible to estimate the budgetary impact

of a complete ban or a substantial reduction in the level of foreign

military sales. Under the current mix of sales, a complete ban on

foreign military sales would on the average result in the loss of savings

of $560 million per year, which includes a $160 million loss in R&D recoupments. If the level of sales were to be reduced to $4 billion and the

percentage of sales with the potential to generate savings were to remain

at the current level of 50 percent, then the loss in savings would be

$280 million per year, including an $80 million loss in R&D recoupments.

However, if the mix of sales for a $4 billion program were assumed to be

similar to the mix under $4 billion programs in previous years (70 percent of sales have the potential to generate savings), then the loss in

savings would be $168 million per year, including $48 million in R&D

recoupments.

(21)
22

TABLE 7

AVERAGE SAVINGS PER DOLLAR OF SALES FOR

FOREIGN MILITARY SALES PROGRAM

(dollars)

Total Savings R&D Savings Other Categories

Mix 1 .07 .02 .05

Mix 2 .10 .03 .07

TABLE 8

TOTAL SAVINGS

(Millions of dollars)

$8 Billion Sales Program $4 Billion Sales Program

Mix 1 560 280

Mix 2 784 392

TABLE 9

R&D SAVINGS

(Millions of dollars)

$8 Billion Sales Program $4 Billion Sales Program

Mix 1 160 80

Mix 2 224 112
TECHNICAL APPENDIX A

The purpose of this appendix is to discuss the estimation of the

average savings per dollar of sales for sales which generate savings.

The following discussion focuses on three alternative estimators: the mean,

the weighted mean, and an estimator based on a logarithmic model. The

logarithmic model was the one used for the estimates presented in the main

body of the report. Following th6 discussion of the three alternative

estimators, .a comparison is made of the alternative estimates for the data

on sales and savings for the 35 weapon systems.

The Sample Mean

One estimator of the average savings-sales ratio is the sample mean

savings-sales ratio:

rt

Ii

X.

Where Y. is the savings for system i

Where X is the sales for system i i

n is the number of systems in the sample

3 is the sample mean ratio.

This estimator is the least squares estimator for a model of sales and

savings of the following form:

Yi

where u^ is a random variable with expected value of

zero and a variance of o2.

(23)
24

Weighted Mean

A second estimator for the dollar value of savings per dollar of

sales, B, is a weighted average of the sample savings-sale ratios;

The above estimator is a weighted one since

n

In contrast to the unweighted mean which gives equal weight to each observation, this estimator gives a weight to system i which is proportional

to the magnitude of sales for that system as a percentage of total sales

for all systems in the data base. This estimator is a least squares

estimator for the following model:

J

where u-; is a random variable with an expected value of zero and a variance

of CT2.

While the estimator for the variance of the sample mean is straight forward,

being equal to

n(n-l)

the estimator for the variance of the weighted mean is not quite so straightforward. It equals

n

-&

(n-1)
25

Logarithmic Model

The two previous estimates are maximum likelihood estimators for a

savings-sale ratio which is normally distributed. However, the normal

distribution is a symmetric distribition with infinitely long tails.

Since the savings-sales ratios are by definition nonnegative the normality

assumption is clearly an approximation. The distortion in estimating B,

the average sales-savings ratio, which may result from this approximation

is especially troublesome if B is small. An alternative estimator is one

based on the assumption that the savings-sales ratio is lognormally distributed. The lognormal distribution is a nonnegative distribution which

provides a better estimate if B is small. The underlying mail is:

1

AXT- '

 p = S 1 ;

where u - is lognormally distributed. Note that this model is linear in

the logarithms so that

ln(!i-) .,„,*,„ U1>

where In u-j is a normally distributed random variable with an expected

value of zero and a variance of a

 2.

The estimator used for B is the so-called "jackknife" estimator, as discussed by Miller. ' Estimation of the variance of the jackknife estimator

is also discussed in the same reference. The logarithmic model was the

one used to estimate the average savings-sales.ratio in the main body of

the report.

Comparison of Results

Table A contains the results of estimation of the savings-sales ratio

using the three alternative estimators. The unweighted and weighted means give

similar results. As one would expect both estimates are higher than the

results using the logarithmic model.

1. Rupert L. Miller, "A Trustworthy Jackknife," Annals of Mathematical

Statistics. Vol. 35 (1964), pp 1684 - 1695.
26

Table A

ALTERNATIVE ESTIMATES OF AVERAGE SAVINGS-SALES RATIO

Total Savings

Logarithmic

Sample Mean Weighted Mean Model

Average Ratio .21 .16 .14

Standard Error .03 .02 .02

R&D Savings

Average Ratio .04 .05 .04

Standard Error .01 .01 .01

o