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Overhead Costs: Unallowable and Questionable Costs Charged by E-Systems,
Inc. (Letter Report, 03/28/94, GAO/NSIAD-94-113).

GAO's review of the overhead cost submissions of E-Systems, Inc., a
large defense contractor, revealed about $120,000 in unallowable costs
out of $16 million in general and administrative transactions. The costs
included personal use of company cars, public relations efforts,
chartered aircraft flights, and legal expenses. GAO also found another
$2.8 million in questionable charges, mainly because E-Systems did not
keep or was unable to provide enough documentation for GAO to determine
the allowability of the questioned costs. GAO also considered more than
$39,000 in travel costs to be excessive. The Defense Contract Audit
Agency (DCAA) has also questioned E-Systems' overhead costs. DCAA has
concluded, and GAO agrees, that E-Systems' internal controls for
identifying and segregating unallowable costs did not guarantee that
only allowable costs were included in the company's overhead cost
submissions.

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

 REPORTNUM:  NSIAD-94-113
     TITLE:  Overhead Costs: Unallowable and Questionable Costs Charged 
             by E-Systems, Inc.
      DATE:  03/28/94
   SUBJECT:  Overhead costs
             Questionable payments
             Defense procurement
             Accounting procedures
             Internal controls
             Overpayments
             Department of Defense contractors
             Billing procedures
             Contract costs

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

Report to Congressional Requesters

March 1994

OVERHEAD COSTS - UNALLOWABLE AND
QUESTIONABLE COSTS CHARGED BY
E-SYSTEMS, INC. 

GAO/NSIAD-94-113

Overhead Costs

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

  DCAA - Defense Contract Audit Agency
  DOD - Department of Defense
  FAR - Federal Acquisition Regulation
  IRS - Internal Revenue Service

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

B-253443

March 28, 1994

The Honorable Jim Sasser
Chairman, Committee on the Budget
United States Senate

The Honorable Kent Conrad
United States Senate

As you requested, we reviewed the overhead cost submissions of
E-Systems, Inc., to determine if they included unallowable costs.  We
reviewed $16 million of the $362.8 million in general and
administrative expenses for 1989-92 for E-Systems' corporate
headquarters; its Greenville, Texas, division; and Serv-Air, Inc., a
subsidiary.  This report also discusses the results of the Defense
Contract Audit Agency's (DCAA) latest audits of E-Systems and whether
E-Systems' internal controls can adequately identify and segregate
unallowable costs. 

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

Contractor overhead submissions establish overhead rates used in the
settlement of cost-type contracts.  They also provide the historical
cost basis for overhead rates used in the negotiation of fixed-price
contracts. 

The Federal Acquisition Regulation (FAR) cost principles require
defense contractors to identify and exclude unallowable costs from
their overhead submissions.  Contractors are also required to certify
that, to the best of their knowledge, their submissions do not
include unallowable costs. 

We have previously identified instances in which defense contractors
have included unallowable or questionable costs in their overhead
submissions.  For example, in November 1992, we reported that six
smaller defense contractors included about $2 million in unallowable
and questionable costs in their overhead submissions.\1 Also, in
October 1993, we testified that McDonnell Douglas Corporation, a
large defense contractor, included $1.6 million in unallowable and
questionable costs in its overhead cost submissions.\2

E-Systems, Inc., was 34th on the 1993 list of the top 100 defense
contractors by revenue.  E-Systems' sales to the U.S.  government
amounted to about $1.6 billion, $1.8 billion, and $1.9 billion for
1990-92, respectively, and accounted for about 90 percent of its
total net sales for 1990-92.  In 1992, about 48 percent of E-Systems'
government sales were made by the two business segments we examined. 

--------------------
\1 Contract Pricing:  Unallowable Costs Charged to Defense Contracts
(GAO/NSIAD-93-79,
Nov.  20, 1992). 

\2 Overhead Costs:  Unallowable and Questionable Costs Charged by
McDonnell Douglas Corporation (GAO/T-NSIAD-94-60, Oct.  13, 1993). 

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

Our review of $16 million in general and administrative transactions
identified about $120,000 in unallowable costs.  These included costs
for personal use of automobiles, public relations, travel, and legal
services.  Our review also disclosed another $2.8 million in
questionable charges principally because E-Systems did not keep or
was unable to provide sufficient documentation for us to determine
the allowability of the questioned costs.  We also considered over
$39,000 in travel costs to be excessive. 

DCAA has also questioned E-Systems' overhead costs.  During the last
three annual audits of E-Systems corporate headquarters' overhead
submissions (1988-90), DCAA questioned about $3.3 million in overhead
costs.  Also, during the last two overhead audits of E-Systems'
Greenville division (1988 and 1989) and Serv-Air (1988 and 1989),
DCAA questioned about $957,000 and $502,000, respectively, in
overhead costs.  DCAA has concluded, and we agree, that E-Systems'
internal controls for identifying and segregating unallowable costs
were, in some respects, inadequate to ensure that only allowable
costs were included in the company's overhead cost submissions.  Not
all of the unallowable or questionable costs we identified represent
overcharges to the government.  These costs were included in the
contractor's overhead pool and, if not detected, a portion would have
been allocated to its defense work.  The actual amount of overcharges
would depend on the amount of defense versus commercial business
performed by the contractor and the types of contracts with the
government.  In addition to being charged to government cost-type
contracts, undetected unallowable costs may affect the negotiation of
fixed-price contracts. 

   UNALLOWABLE COSTS
------------------------------------------------------------ Letter :3

We identified about $120,000 in unallowable general and
administrative expenses included in E-Systems' overhead submissions. 
These include costs for personal use of automobiles, public
relations, travel, and legal services.  Appendix I lists these costs
and the specific reference or FAR cost principle that makes them
unallowable. 

      PERSONAL USE OF AUTOMOBILES
---------------------------------------------------------- Letter :3.1

According to the FAR, the cost of using company-furnished vehicles
for employees' personal use is unallowable compensation.  The
employee compensation is reported to the Internal Revenue Service
(IRS) as taxable income, while the cost to the company is deducted
from its cost submissions.  To correctly report and exclude
unallowable cost for personal use of company vehicles from the
overhead submissions, the contractor's internal controls must be
adequate to ensure complete records of employees assigned company
vehicles and their personal use mileage. 

Corporate headquarters from 1989 to 1992 did not have adequate
records of employees' assigned company vehicles and their personal
use mileage.  In 1989 and 1990 corporate records were not adequate to
calculate personal use cost for five employees, which should have
been excluded from the submissions.  In 1991, we could not determine
if personal use costs were properly excluded from the submission
because the company was unable to supply a list of employees assigned
vehicles for the entire period.  In 1992, personal use costs for one
employee was not excluded from the submission.  Based on the reported
average personal use in each year, we estimate the company did not
exclude about $28,000 for personal use of company vehicles from its
submissions.  Inadequate records on personal use of company vehicles,
we observed, also resulted in the contractor not reporting income to
the IRS for three to five employees in each of the years we reviewed. 

      PUBLIC RELATIONS
---------------------------------------------------------- Letter :3.2

The FAR states that public relations costs as well as the applicable
portion of salaries, travel, and fringe benefits of employees engaged
in the functions are unallowable if the primary purpose is to promote
the sale of products or services or enhance the company's image.  We
identified $11,600 for employee attendance at government ceremonies
that we believe were unallowable public relations functions.  This
amount included about $7,350 for employees to attend military
change-of-command ceremonies.  For example, two company vice
presidents and two employees flew in the corporate airplane from
Greenville, Texas, to Beale Air Force Base, California, to attend the
change-of-command ceremony for the Air Combat Command on August 18,
1992.  The 1-day trip, which cost $3,584, was charged as an allowable
travel cost. 

      TRAVEL
---------------------------------------------------------- Letter :3.3

Airfare costs are limited to the cost of the lowest standard
commercial airfare, according to the FAR.  However, E-Systems
included the full cost of two chartered aircraft flights in its
overhead claim.  These chartered flights, costing about $19,300, are
significantly more than the maximum amount allowed, based on standard
commercial fares.  For example, in June 1989, three company
executives chartered an aircraft for a trip to an investment
conference in South Carolina.  This flight cost $13,019, or about
$4,340 per person.  If standard commercial airfares for these
executives had been used, the allowable cost would have been about
$11,000 less. 

We also identified about $27,100 in travel costs incurred by
employees planning or executing unallowable mergers and acquisitions
activities.  The FAR states that expenses associated with such
activities are unallowable.  Other unallowable travel costs totaling
$11,300 were for activities such as social events and travel for
personal convenience. 

      LEGAL SERVICES
---------------------------------------------------------- Letter :3.4

According to the FAR, legal expenses associated with a proceeding
brought by the Federal government are partially or wholly unallowable
depending on the outcome of the proceeding.  Unallowable legal
expenses also include patent costs that are not incurred as
requirements of a government contract.  We identified abut $23,000 in
unallowable legal expenses.  For example, E-Systems spent about
$35,200 in connection with a federal grand jury proceeding concerning
the theft of government property.  The costs were incurred in
responding to a subpoena and conducting an investigation of the theft
allegations.  The grand jury proceeding was terminated after the
company reported its findings.  When a federal proceeding results in
no finding of wrongdoing by the contractor, allowable legal expenses
are limited to 80 percent of the incurred costs, or $28,200 in this
case.  Thus, the difference of $7,000 is unallowable. 

E-Systems also included in overhead $1,500 to replenish a deposit
account with the Patent and Trademark Office for patent costs. 
However, patent expenses paid from this account were not shown to be
required by any government contract.  This was also true of $10,300
in other patent costs.  In addition, in 1990, E-Systems entered into
an agreement with the government in which it pleaded guilty to
conspiracy to defraud the United States and to making false claims
against the United States.  The company agreed to disallow all costs
incurred in connection with its defense in civil and criminal
proceedings of this case.  However, about $4,200 related to the
company's defense was charged to allowable overhead accounts. 

   QUESTIONABLE COSTS
------------------------------------------------------------ Letter :4

We questioned $2.8 million in expenses due to inadequate
documentation and excessive travel costs.  Additional documentation
and reconstruction of unrecorded activities will likely result in
some portion of the questioned costs being reclassified as
unallowable and some portion remaining as allowable.  Appendix II
lists all of the questionable costs and the specific reference or FAR
cost principle that is applicable to them. 

      INADEQUATE DOCUMENTATION OF
      COSTS
---------------------------------------------------------- Letter :4.1

We questioned about $2.7 million in overhead cost submissions because
E-Systems did not keep or was unable to provide sufficient
documentation for us to determine the allowability of submitted
costs.  One of the expenses associated with the questioned cost
submissions was for a new business development unit that E-Systems
created to, among other things, identify, investigate, and analyze
possible acquisition and merger opportunities.  Even though expenses
related to acquisitions and mergers are unallowable, most of this
unit's expenses (about $1.9 million) was submitted as allowable. 
E-Systems did not keep records to permit segregating these expenses
between allowable and unallowable activities. 

In addition, legal services performed for E-Systems lacked the
supporting documentation required by the FAR.  The bills received for
these services did not include the time spent on each service, who
rendered the service, and how much the service cost.  Without this
information, we could not determine whether the cost was reasonable. 
Also, about $89,000 of travel expenses for company employees was
classified as allowable, even though there was not sufficient
documentation showing the purpose for the travel, as required by the
FAR.  E-Systems subsequently provided documentation showing that
about $19,600 in travel expenses was for allowable purposes and
$27,100 was directly associated with unallowable mergers and
acquisition activities.  We questioned the remaining $42,300 because
the company could not demonstrate that the travel was for allowable
purposes. 

      REASONABLENESS OF TRAVEL
      COSTS
---------------------------------------------------------- Letter :4.2

We also questioned whether about $39,400 in travel expenses were
allowable.  The expenses included $1,100 for limousine services for
company executives when other, less costly means of transportation,
such as taxicabs or rental cars, appeared to be available.  For
example, company executives rented a limousine for 9-1/2 hours at a
total cost of $389 and asserted, without supporting cost
documentation, that the limousine service was less costly than a
taxicab because of the number of meetings and their different
locations. 

The expenses also included the use of the corporate aircraft to
transport cargo at passenger rates.  In general, the cargo was not
adequately identified and weighed to permit exact determination of
what the cost would have been to ship the cargo commercially. 
However, on the basis of a general cargo description, we believe some
could have been shipped commercially for less cost.  For example, the
company charged $5,128 for delivering a contract proposal from
corporate headquarters in Dallas, Texas, to Washington, D.C.  The
proposal, which was shipped in several boxes over a 2-day period,
weighed about 600 pounds.  According to DCAA, shipment by commercial
overnight express would have cost about $1,000.  Further, this and
other cargo was shipped one-way, yet the company charged for a
round-trip.  The difference between the round-trip charged and a
one-way trip for 1990 and 1991 amounted to about $20,100, which is
the amount we questioned.  Also, the corporate aircraft was used to
transport non-employees, such as city officials and foreign
customers, at a total cost of $11,200.  Finally, about $7,000 of
travel expenses for employees was questioned because it appeared
unreasonable. 

   DCAA'S REVIEW OF E-SYSTEMS
------------------------------------------------------------ Letter :5

DCAA also questioned E-Systems' overhead costs.  During its audits of
corporate headquarters' 1988-90 overhead submissions, DCAA questioned
about $3.3 million of the $75 million claimed.  Questioned costs
included about $578,000 for deferred compensation payable to
directors, $99,000 for lobbying, $218,000 in recruitment advertising,
$101,000 for travel, $249,000 for employee compensation, and $449,000
for a supplemental executive retirement plan. 

During its audits of the Greenville division's 1988 and 1989 overhead
proposals, DCAA questioned about $957,000 of the $89 million claimed. 
Questioned costs included about $451,000 in domestic field office
allowance, $139,000 in domestic marketing, and $56,000 in legal,
consultant, and audit costs. 

During its audits of Serv-Air, Inc.'s 1988 and 1989 overhead
proposals, DCAA questioned about $502,000 of the $12.5 million
claimed.  Questioned costs included $229,000 in dental insurance,
$101,000 in franchise taxes, and $17,000 in recruitment advertising. 

In its 1993 audit of internal controls covering the accounting for
unallowable costs at E-Systems corporate headquarters, DCAA concluded
that the company's internal controls for identifying and segregating
unallowable cost are, in some respects, inadequate to ensure that
only allowable costs were included in overhead cost submissions.  For
example, the company lacks formal written policies and procedures
covering the identification and segregation of unallowable costs.  On
the basis of our findings, we agree with DCAA that E-Systems'
internal controls are not adequate to identify and exclude
unallowable costs. 

DCAA also concluded in its audit that the risk of significant
unallowable costs being charged to government contracts was minimized
because E-Systems' employees that process vouchers and prepare cost
submissions are experienced in performing their duties without
written policies and procedures.  However, employee turnover could
significantly alter this risk. 

   E-SYSTEMS RESPONSE TO OUR
   FINDINGS
------------------------------------------------------------ Letter :6

E-Systems agreed with most of the findings in this report.  It
acknowledged that it did not identify unallowable costs in some cases
or sufficiently document other costs so that allowability could be
determined. 

E-Systems said the findings in this report were relatively
insignificant, considering the complex and changing regulations with
which the company must comply.  Nevertheless, it said it would
improve its controls to avoid future inappropriate charges to
overhead and to improve documentation of cost charges.  The company
agreed that it should eliminate all unallowable costs in its overhead
submissions. 

   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

We selected E-Systems, Inc., of Dallas, Texas, for our review because
it was 1 of the top 100 defense contractors by revenue and because we
could obtain a wide variety of activity with corporate headquarters,
a manufacturing division, and a wholly owned subsidiary within the
same geographical area.  In our examination of E-Systems' indirect
costs, we reviewed the overhead submissions for 1989-92 for those
accounts we believed to be vulnerable to overbilling.  We focused
principally on 1990-92 since these years had not been completed by
DCAA.  We selected individual summary vouchers that appeared to be
questionable.  We then traced voucher costs to documentation
supporting their nature and purpose and determined whether the costs
were allowable under the applicable FAR cost principles. 

We conducted our work between November 1992 and September 1993 in
accordance with generally accepted government auditing standards.  As
requested by your office, we did not obtain written agency comments
on a draft of this report.  However, we discussed the results of our
review with appropriate E-Systems' and DOD officials and incorporated
their comments where appropriate. 

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

Copies of this report are being sent to the Secretary of Defense; the
Director, Defense Contract Audit Agency; the Director, Office of
Management and Budget; and other interested parties.  We will also
make copies available to others on request. 

Please contact me at (202) 512-4587 if you or your staff have any
questions concerning this report.  Other major contributors to this
report are listed in appendix III.

David E.  Cooper
Director, Acquisition Policy, Technology,
 and Competitiveness Issues

E-SYSTEMS' UNALLOWABLE OVERHEAD
COSTS
=========================================================== Appendix I

Unallowable cost
claimed               Business segment      Cost principle                Amount
--------------------  --------------------  --------------------  --------------
Personal use of       Headquarters          FAR 31.205-6(m)(2)           $28,000
automobile

Public relations      All                   FAR 31.205-1                  11,600

Merger/acquisition    Headquarters          FAR 31.205-27                 27,100
associated
travel costs

Excessive travel      All                   FAR 31.205-46                 15,800
costs

Other unallowable     All                   FAR 31.205-46                 11,300
travel

Legal services
--------------------------------------------------------------------------------
Response to Grand     Serv-Air              FAR 31.205-47 (e)              7,000
Jury subpoena

Patent                Headquarters          FAR 31.205-30                  1,500

Patent                Greenville            FAR 31.205-30                 10,300

Criminal prosecution  Headquarters          Plea agreement                 4,200
of                                          between Justice
four employees                              Dept. and E-Systems

Directly associated   All                   FAR 31.201-6                   3,400
costs

================================================================================
Total                                                                   $120,200
--------------------------------------------------------------------------------
Note:  Dollar amounts have been rounded. 

E-SYSTEMS' QUESTIONABLE OVERHEAD
COSTS
========================================================== Appendix II

Questionable cost
claimed               Business segment      Cost principle                Amount
--------------------  --------------------  --------------------  --------------
Travel reasonableness
--------------------------------------------------------------------------------
Use of limousine      Headquarters          FAR 31.201-2 and -3           $1,100

Use of corporate
aircraft

Cargo                 Greenville            FAR 31.201-2 and -3           20,100

Non-employees         Greenville            FAR 31.205-46                 11,200

Employees             All                   FAR 31.201-2 and -3            7,000

================================================================================
Subtotal                                                                  39,400

Lack of documentation
--------------------------------------------------------------------------------
New business unit     Headquarters          FAR 31.205-27              1,900,000

Legal
--------------------------------------------------------------------------------
Investigation of      Headquarters          FAR 31.205-33                752,800
corporate liability
for wrongdoing

Wrongful discharge    Greenville            FAR 31.205-33                 41,600

Investigation         All                   FAR 31.205-33                 12,100

Miscellaneous patent  Headquarters          FAR 31.205-33                  4,900

Patent matters        Headquarters          FAR 31.205-33                  2,600

Travel expenses       All                   E-Systems' travel             42,300
                                            directives

================================================================================
Total                                                                 $2,795,700
--------------------------------------------------------------------------------
Note:  Dollar amounts have been rounded. 

MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix III

   NATIONAL SECURITY AND
   INTERNATIONAL AFFAIRS DIVISION,
   WASHINGTON, D.C. 
------------------------------------------------------- Appendix III:1

Lester C.  Farrington, Jr., Assistant Director
Charles W.  Thompson, Assistant Director

   DALLAS REGIONAL OFFICE
------------------------------------------------------- Appendix III:2

Joe D.  Quicksall, Evaluator-in-Charge
John E.  Clary, Site Senior
Ronald J.  Salo, Senior Evaluator
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