United States General Accounting Office

GAO Report to Congressional Committees

March 1995 DEFENSE BUSINESS

OPERATIONS FUND

Management Issues

Challenge Fund

Implementation

GAO/AIMD-95-79

GAO United States

General Accounting Office

Washington, D.C. 20548

Accounting and Information

Management Division

B-259833 

March 1, 1995

Congressional Committees

The National Defense Authorization Act for Fiscal Year 19951

 directed the

Secretary of Defense to submit to the congressional defense committees a

report on the progress made in implementing the September 1993 Defense

Business Operations Fund Improvement Plan by February 1, 1995. The act

further requires that we evaluate and report on the Department of

Defense’s (DOD) progress and make whatever recommendations for

legislative or administrative action we consider appropriate. This report

provides our (1) assessment of DOD’s progress in correcting the ongoing

problems that have hindered the Fund’s operations and

(2) recommendations to the Congress and DOD to address our concerns.

Since the concept of the Fund was first put forth in February 1991, we

have monitored and evaluated its implementation and operation. We have

previously reported2

 that DOD has not achieved the Fund’s objectives

because

• policies critical to the Fund’s operations either were not developed or

needed to be revised;

• the Fund’s financial reports were inaccurate; and

• the cost accounting systems were fragmented, costly to maintain, and did

not provide the cost information necessary for managers to better control

costs.

The Fund’s problems are symptomatic of the weaknesses in DOD’s overall

financial management environment. GAO, congressional committees, and

the DOD Inspector General have continually highlighted pervasive

problems in DOD’s financial operations, which we have designated as a

high risk area.3

 To its credit, DOD’s fiscal years 1993 and 1994 Federal

Managers’ Financial Integrity Act reports have presented a forthright

assessment of its shortcomings in financial management.

To specifically address the serious problems affecting the operation of the

Fund, on September 24, 1993, the Deputy Secretary of Defense and the

Secretaries of the Army, Navy, and Air Force approved the Defense

1

Public Law 103-337, October 5, 1994.

2

See Related GAO Products list in the back of this report.

3

High Risk Series: An Overview (GAO/HR-95-1, February 1995).

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Business Operations Fund Improvement Plan, which consists of 56 actions

aimed at improving the Fund’s operations and addressing known

deficiencies. On March 9, 1994, we reported that DOD had made some

progress in completing the actions called for in the plan. However, we

pointed out that much work remained to be completed since most of the

actions that dealt with the Fund’s policies, procedures, systems, and

reports were scheduled to be completed by the end of fiscal year 1994 or

in fiscal year 1995.

Results in Brief If properly implemented, the Fund can contribute to improvements in

DOD’s operations. However, DOD continues to face serious problems that

have hindered its past management of the Fund. While DOD has made some

progress over the past 16 months,4

 we disagree with DOD’s assessment in

its February 1, 1995, progress report to the congressional defense

committees that it has made “tremendous progress in rectifying or

reducing many of the problems in the Plan.” After more than 3 years of

operations, very little has changed in the day-to-day operations of the

Fund’s business areas. Specifically, we found the following:

• DOD does not have a systematic process in place to ensure that the Fund’s

policies are implemented consistently. Consequently, Fund managers lack

the necessary guidance to execute day-to-day operations of the Fund.

• DOD has selected most of the Fund’s interim migratory systems without

first determining the total estimated cost to enhance and implement these

systems across the Fund’s business areas.

• DOD is still having difficulty preparing accurate financial reports on the

Fund’s operations. For example, the monthly reports show negative

balances of hundreds of millions of dollars for certain accounts such as

inventory, accounts receivables, and revenue.

• DOD has reversed its cash management policy by returning cash control to

the DOD components. This is a major departure from the benefit of a single

cash balance that DOD cited when it established the Fund.

In addition, we have concerns with several of the Fund’s policies. For

instance, DOD’s policy calls for the recovery of prior year losses through an

increase in subsequent years prices that the Fund will charge its

customers. We have previously stated that DOD should seek additional

funds through the appropriation process, thereby providing the Congress

4

The period of time from the issuance of the Defense Business Operations Fund Improvement Plan in

September 1993 to DOD’s February 1995 Fund report to the congressional defense committees.

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with critical information needed for effective oversight of the management

and operations of the Fund.

Background In October 1991, DOD implemented the Fund, which consolidated the nine

existing industrial and stock funds operated by the military services and

DOD, as well as the Defense Finance and Accounting Service (DFAS), the

Defense Industrial Plant Equipment Service, the Defense Commissary

Agency, the Defense Reutilization and Marketing Service, and the Defense

Technical Information Service. The Fund’s primary goal is to focus the

attention of all levels of DOD management on the total costs of carrying out

certain critical DOD business operations and to manage those costs

effectively. This goal is in accordance with the objectives of the National

Performance Review (NPR), which is aimed at achieving cost efficiencies in

the federal government.

The Fund is modeled after businesslike operations in that it maintains a

contractual (buyer-seller) type of relationship with its customers,

primarily the military services. In fiscal year 1995, the Fund will have

estimated revenue of $77 billion, which would make it equivalent to one of

the largest corporations in the world. The Fund provides such essential

goods and services as the (1) overhaul of ships, tanks, and aircraft and

(2) sale of over 5 million types of vital inventory items, such as landing

gears for aircraft. Many of these services are essential to maintaining the

military readiness of our country’s weapon systems. Unlike a private

sector enterprise which has a profit motive, the Fund is to operate on a

break-even basis by recovering the current costs incurred in conducting its

operations.

Scope and

Methodology

To accomplish our objectives, we reviewed DOD’s quarterly progress

reports on the implementation of the plan and DOD’s February 1, 1995,

progress report to the congressional defense committees on the Fund. We

also met with DOD officials to determine if DOD had completed the

following three actions within the milestones established in the plan:

(1) complete all Fund policies by December 31, 1994, (2) select the

systems to account for Fund resources by September 30, 1994, and begin

implementing those systems by December 31, 1994, and (3) improve the

accuracy of the financial data in the Fund’s monthly financial reports by

December 31, 1994.

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To evaluate DOD’s efforts to select the Fund’s financial systems, we

reviewed the system evaluation reports prepared for the 28 systems

reviewed by DOD. We also met with representatives from DFAS, as well as

representatives from other DOD components involved in the system

selection process, to determine the system selection criteria and their

appropriateness. We also determined what plans DOD has in place to

(1) implement/enhance the selected systems, (2) estimate the costs to

improve the selected systems, and (3) eliminate the systems not selected.

To determine whether DOD has improved the data accuracy in the Fund’s

monthly financial reports, we met with officials in DFAS to ascertain and

evaluate actions taken (or planned) to improve data accuracy, including

actions to enable reconciliation between the Fund’s cash balance and the

corresponding balance maintained by Treasury. We also analyzed the

Fund’s monthly financial reports to determine whether the systems are

producing accurate and complete financial data. Further, we obtained the

reports of the DOD Inspector General’s audit of the Fund’s fiscal years 1992

and 1993 financial statements required by the Chief Financial Officers

(CFO) Act of 1990.

We performed our work at the Office of the Secretary of Defense

(Comptroller); the Departments of the Army, Navy, and Air Force; the

Defense Logistics Agency (DLA); DFAS headquarters; and the Cleveland,

Columbus, Denver, and Indianapolis DFAS Centers. Our review was

performed from July 1994 through February 1995, in accordance with

generally accepted government auditing standards.

We discussed the facts, conclusions, and recommendations in our report

with cognizant DOD officials and have incorporated their comments where

appropriate.

Little Improvement

Made in the

Day-to-Day

Operations of the

Fund

DOD has made some progress in addressing the problems that have plagued

the Fund’s operations. During the past 16 months, DOD has made decisions

such as developing and approving Fund policies, revising the format of the

Fund’s financial reports, and selecting 12 interim migratory financial

systems to account for the Fund’s resources. However, we disagree with

DOD’s assessment in its February 1, 1995, progress report on the Fund that

it had made “tremendous progress in rectifying or reducing the problems

in the Plan.”

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Little improvement has yet been made in the actual day-to-day operations

of the Fund. Since the Fund began operations in October 1991, it has not

been able to meet its financial goal of operating on a break-even basis. The

reported loss for fiscal year 1994 will mark the third consecutive year of

operating losses. A key element in reducing the cost of operations is the

ability to accurately identify total costs. However, DOD lacks the

management tools to accomplish this task. Specifically, DOD has not

(1) developed a process to ensure the Fund’s policies are consistently

implemented, (2) improved the accuracy and reliability of the Fund’s

systems, (3) improved the Fund’s monthly financial reports, (4) adequately

managed the Fund’s cash, and (5) developed performance measures and

goals. These problems are discussed below.

Process to Ensure Policy

Implementation Not in

Place

DOD has acknowledged that its failure to develop policies and procedures

has been one of the most significant weaknesses of the Fund’s

implementation. In its September 1993 plan, DOD identified several actions

to address this problem. In December 1994, DOD completed and issued the

Financial Management Regulation (FMR) on the Fund, which contains the

Fund’s financial policies.5

 This regulation is a major step toward

standardizing the Fund’s operations. It consolidates all policies of the old

industrial and stock funds, changes that have been made to those policies,

and new policies that have been issued since the Fund was established.

However, confusion exists within DOD regarding the need for implementing

procedures to accompany the various policies that have been issued. As a

result, the five policies6

 that the Deputy Comptroller for Financial Systems

stated were to be effective October 1, 1994, had not been implemented

throughout DOD as of January 1995. According to DFAS officials, they are

responsible for developing implementing procedures for each Fund policy

approved by the DOD Comptroller. DFAS’ position is supported by a

memorandum from the Deputy Comptroller for Financial Systems that

states that DFAS is developing accounting procedures as necessary to

ensure the policies can be implemented.

DOD Comptroller officials informed us that it was not necessary for DFAS

headquarters to develop implementing procedures because the FMR

5

As of January 1995, DOD was still developing or reviewing the following policies: (1) capital assets,

(2) accounting for miscellaneous items, (3) intrafund transactions, (4) cost comparison for competed

workloads, (5) full funding, and (6) dual funded organizations.

6

These policies pertain to (1) cash management, (2) major real property maintenance and repair,

(3) military personnel pricing, (4) customer mandated schedule changes, and (5) management

headquarters costs.

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already contains them. The officials further stated that DOD is trying to

avoid the proliferation of procedures by DFAS and its field activities so that

the Fund’s policies will not be implemented inconsistently as a result of

different interpretations, as has happened in the past. In fact, the

improvement plan notes that the Fund’s financial reports reflect the

results of applying policies inconsistently across business areas. Given the

October 1994 memorandum, other DOD documents on Fund policy

implementation, and the opinion of DOD Comptroller officials, it is evident

that DOD has not resolved this issue. Until it does so, the FMR may not be

implemented in a timely manner.

Given the immense size, complexity, and scope of the Fund’s $77 billion

operation, the need to complete the development of the policies and

consistently implement them is particularly acute. Until consistent

implementation is achieved, the benefits of the new policies will not be

realized. Without standard policies and procedures, Fund managers are

forced to make their own interpretation regarding how to report on the

respective operations of their business areas. Therefore, it is imperative

that DOD put in place a process which will provide a mechanism for

ensuring that Fund policies are implemented in a timely, consistent

manner.

In addition to implementation issues discussed above, we have concerns

about the provisions in several Fund policies that DOD has developed and

approved thus far. These concerns are highlighted below and discussed in

detail in appendix I.

• DOD’s policy requires that prior year losses be recovered by increasing the

prices charged customers. DOD increased fiscal year 1995 Fund prices by

$1.7 billion to recover prior year losses. We have previously stated that the

Fund, not the customers, should be required to request additional funds

through the congressional appropriation process to recover losses. As part

of the justification, DOD should explain differences such as the variances

between the budgeted and actual results of operations for each business

area. The explanation should also include the causes for the reported gain

or loss and the actions being taken to avoid similar gains or losses in the

future. Our approach would give the Congress an opportunity to review

the Fund’s operations, determine if additional funds are actually needed,

and evaluate the effectiveness of DOD’s management of the Fund. It would

also provide a strong incentive to properly set prices and would help focus

attention on the current costs of operations.

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• DOD’s policy allows for two methods of recognizing revenue for the depot

maintenance area: the completed contract method and the percentage of

completion method. We disagree with the use of the completed contract

method when work done on an order crosses fiscal years. Using the

completed contract method for such orders defers the recognition of

revenue and related expenses to the period in which they were completed.

Therefore, the financial reports distort the financial results of operations

for each fiscal year.

• The military personnel policy provides that the cost of military personnel

will be at the civilian equivalent rate, not the actual cost of military

personnel. This practice will understate the total military personnel costs

since the civilian equivalency rate is 23 percent less than the military

personnel cost. This practice also will not further the objectives of the NPR,

which stipulates that the full costs be included in the prices that providers,

such as the Fund, charge customers so that the total cost of what the

government produces can be determined. However, the National Defense

Authorization Act for Fiscal Year 1994 directs DOD to base its recovery of

military personnel costs on something other than actual costs.7

 We believe

the act should be amended to provide for recovering the full cost of

military personnel.

• The policy on management headquarters costs does not specify which

costs should be allocated in the prices the Fund charges customers.

Because DOD has a complex organization structure—including activities

such as headquarters, major commands, and depots—the military services

and DOD components could interpret the guidance differently.

Accuracy and Reliability of

Financial Systems Not

Improved

One of the primary challenges still confronting DOD is the improvement

and standardization of the Fund’s financial systems. Currently, about 80

disparate and unlinked systems are producing accounting data. DOD has

stated that it needs to apply adequate funds, personnel, and time to solve

existing problems with its financial systems, which continue to produce

inaccurate, inconsistent, and untimely reports on the Fund’s operations.

Systems that produce credible cost data are essential for the successful

operations of the Fund. The ability to charge the Fund customers the total

cost of operations is predicated upon the assumption that the total costs

are known. Accurate cost data are also critical in order to develop

systematic means to reduce the cost of operations.

7

Specifically, the act directs that Fund prices will recover military personnel costs “as computed by

calculating, to the maximum extent practicable, such costs if employees of the Department of Defense

were used in the provision of goods and services.”

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Over the past 16 months, DOD has made some progress towards

accomplishing the actions outlined in the plan. Specifically, DFAS

developed functional8 and technical requirements for the Fund’s financial

systems, completed the evaluation of 28 systems nominated by the military

services and DOD components, and recommended interim migratory

systems. However, DOD has neither developed conversion plans and

procedures nor begun implementing the interim migratory systems for the

Fund’s operations by December 31, 1994, as called for in its plan.

Based on DFAS’ analyses, 17 systems were recommended by DFAS as the

Fund’s interim migratory systems. The highest score a system could

receive was 100 and a score of 75 was needed by the system to meet

minimum Fund functional and technical requirements. None of the 17

systems received the minimum functional score of 75 with the scores

ranging from 22 to 60. Only 3 systems received the minimum technical

score of 75.

According to DOD’s preliminary estimate, it will cost $94.5 million to

enhance the 17 systems to meet the minimum Fund functional

requirements. However, this estimate does not include the following

significant costs: (1) improvements needed to meet the minimum technical

requirements, (2) data conversion from the existing systems to the interim

migratory systems, (3) development of interfaces with nonfinancial

systems, such as logistics and personnel, that generate most of the

financial data, (4) training of personnel who will operate and enter data

into the interim migratory system, and (5) replacement of 63 existing

systems with the interim migratory systems.

DOD acknowledges that these costs will probably be higher than the

estimated costs to enhance the systems’ functionality. However, as of

February 1995, DOD had not completed a functional economic analysis9

 for

the interim migratory systems, which was to have been completed by

March 31, 1994. Although DOD stated that the analysis should be completed

before a system is selected, DOD had already selected 12 of the 17 systems.

To obtain this critical information on the interim migratory systems, on

8

DOD developed a functional requirements document based on the Core Financial Systems

Requirements, which was approved by the Joint Financial Management Improvement Program. DOD

then modified it for revolving fund operations. The document lays out the following 10 major areas:

(1) fund distribution, (2) general ledger, (3) fixed assets, (4) cost accounting, (5) payables,

(6) receivables, (7) billing, (8) disbursing/collections, (9) inventory accounting, and (10) travel.

9

A functional economic analysis includes an evaluation of process requirements or problems, proposed

solutions, alternatives, assumptions, constraints, life cycle costs, benefit/cost analysis, and investment

risk analysis.

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December 19, 1994, the Under Secretary of Defense (Comptroller)

required that a functional economic analysis be prepared for the depot

maintenance and transportation business areas and a cost analysis10 be

prepared for the other business areas before the expenditure of funds to

enhance the systems is authorized. The analyses were to be completed by

the end of March 1995. However, when we discussed our report with DOD

officials, they stated that such an enormous task could not be completed

by that date and had not determined when the analyses would be

completed. Given the relatively low scores the systems received and the

magnitude of the total cost to upgrade them to meet the minimum

functional and technical requirements and implement the selected

systems, we believe a functional economic analysis should be performed

for each of the systems selected as a Fund interim migratory system.

Problems Continue in

Preparing Accurate Fund

Financial Reports

Meaningful and reliable financial reports are essential to enable the

Congress to exercise its oversight responsibilities. Reliable financial

reports are also imperative for DOD management to make informed

decisions on the Fund’s operations and set realistic prices to charge

customers. DOD has acknowledged several times that the Fund’s financial

reports are inaccurate. Accordingly, DOD’s plan for improving Fund

operations identifies a number of actions aimed at improving the accuracy

and usefulness of the Fund’s financial reports.

One of these actions was to revise the Fund’s Monthly Report of

Operations—the 1307 report. Although DOD’s February 1, 1995, report

stated that this action had been completed, we do not agree. DOD issued a

revised 1307 report format in September 1994 that provides for a monthly

income statement, balance sheet, and cash flow statement, which we have

previously suggested. The new reporting format was to be used for the

first time in reporting the December 1994 results of operations. However,

the December data for the Air Force, Navy, Marine Corps, Transportation

Command, and the Defense Information Service Agency was reported in

the old format. When we discussed this report with DOD officials, they

stated that these activities had been directed to submit the December 1994

financial data in the new report format. Improving the accuracy of this

report will require that DFAS headquarters, the DFAS Centers, and the DOD

components work together and agree on the actual source of information

to be used to produce the financial reports.

10A cost analysis is not as detailed as a functional economic analysis. It includes estimates of the costs

to (1) enhance the system to meet minimum functional and technical requirements, (2) develop

interfaces, (3) deploy the systems, and (4) develop implementation milestones. It does not include an

analysis of (1) alternatives, (2) benefits/costs, or (3) life cycle costs.

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Officials responsible for completing the new 1307 report at several DFAS

Centers, told us that the report could not be properly prepared because

the current financial systems did not contain or accumulate all the

necessary data. As a result, the Centers had to use manual workarounds,

in some cases, to obtain the necessary data. Some Center officials were

doubtful that all the data could be obtained. The officials stated that

because of the variety of different data sources that will be used as a result

of the workarounds, the 1307 data will not be consistent and, therefore,

not comparable between similar business areas. In addition, manual

workarounds increased the chance that errors could occur through the

transposition of numbers.

In part, this problem resulted from the Fund’s systems use of 15 different

general ledgers. DOD issued crosswalks that translate the 15 different

general ledgers in use for the Fund to the DOD Standard General Ledger.

The crosswalks were issued with the requirement that they be used in the

formulation of the Fund’s financial reports, including the 1307 report.

However, the crosswalks contained general ledger accounts for which

there were no corresponding accounts in the Centers’ current systems’

general ledger structure. The converse is also true: the Centers’ current

systems’ general ledger structure contained accounts for which no

corresponding account existed in the crosswalks. The Centers had not

received guidance regarding what to do for these situations. Because of

this, officials at one DFAS Center told us they “have no plans to use the

crosswalks anytime soon.” We do not consider this action complete until

DOD can demonstrate that the revised 1307 report is giving DOD

management and the Congress accurate, reliable, and consistent financial

information on the results of the Fund’s operations.

Since March 1993, we have reported that the Fund’s financial reports are

error prone and cannot be relied upon for decision-making purposes.

Further, because of significant deficiencies in the internal controls, the

DOD Inspector General was unable to express an opinion on the Fund’s

fiscal year 1992 and 1993 financial statements, in performing audits

required by the CFO Act. After approximately 3 years of operating the Fund,

DOD is still experiencing difficulty in preparing accurate reports on the

Fund’s operations.

For example, the Fund’s Army supply management business area reported

a fiscal year-end 1994 operating loss of $8.5 billion on a program that had

revenue of $7 billion. After we visited the DFAS-Indianapolis Center, where

we discussed the loss with Center officials, it was determined that a

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clerical error of about $6 billion had been made on the fiscal year-end 1994

financial report for Army supply management and the report was revised

to show a fiscal year 1994 loss of over $2.6 billion. Our analysis of the

Fund’s fiscal year 1994 monthly financial reports disclosed numerous

other instances in which the reports were inaccurate. Because of these

reporting problems, DOD cannot be certain (1) of the actual operating

results for the Fund or (2) if the prices the Fund will charge its customers

are reasonable. Until DOD and the Fund can achieve an integrated financial

management system, financial reports will continue to be error prone.

These problems are discussed in appendix II.

DOD Has Reversed Fund’s

Cash Management Policy

Since the Fund was established, its cash balance has been centrally

managed by the Office of the Secretary of Defense (Comptroller). On

February 1, 1995, DOD returned the management of the Fund’s cash and

related Antideficiency Act11 limitations to the military service and DOD

component level. When we discussed our report with DOD officials, they

stated that the policy had been changed to better align accountability and

responsibility for cash management. However, there is no assurance that

this policy change will enhance DOD’s cash accountability. This policy

change is a major departure from the benefits of a single cash balance DOD

cited in establishing the Fund. In our prior testimony, we pointed out that

by consolidating the cash balances of the old industrial and stock funds,

DOD reduced by several billion dollars the Fund’s cash requirement needs.12

DOD’s action may increase the Fund’s cash requirements and, therefore,

increase the need for appropriated funds to implement the change or the

continued advance billing of customers for goods and services they are to

receive.

In the March 1991 Defense Business Operations Fund Overview Book on

the budget, DOD informed the congressional defense committees that

“the single DBOF fund balance provides flexibility during execution necessary to absorb

varying financial conditions. Combining previously separate appropriations into one

account, united by support and business function aspects, allows lower total fund balances

through a form of self-insurance not previously available. Operating fund balances for the

former stock and industrial funds are significantly reduced in this budget.”

11The Antideficiency Act provides in part that, unless otherwise authorized by law, no officer or

employee of the United States shall make expenditures or incur obligations exceeding the level of the

available appropriation, an apportionment, or specific other limits set by agencies (31 U.S.C. 1517 and

1341).

12Financial Management: Opportunities to Strengthen Management of the Defense Business Operations

Fund (GAO/T-AFMD-93-4, May 13, 1993).

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In February 1992, DOD again reiterated the benefits of maintaining a single

cash balance for the Fund. Further, the September 1993 plan specifically

provided that the Antideficiency controls would remain at the Office of the

Secretary of Defense (Comptroller) level.

DOD has been experiencing a cash shortage problem since about June 1993.

Because of this shortage, the DOD Principal Deputy Comptroller directed in

June 1993 that all depot maintenance activities and selected research and

development activities advance bill customers for goods and services to be

provided. In July 1994, the Comptroller of Defense stopped the advanced

billing at all activities except the Naval shipyards and research and

development activities. Although these remaining activities had been

tentatively scheduled to stop advance billing in January 1995, they had not

done so as of February 1995. As we have stated in the past, we believe that

advance billing is a stopgap measure and not a sound business practice.

The policy change placing the management of cash at the military services

and DOD component level could increase the Fund’s cash needs, resulting

in the possibility that other Fund activities will advance bill their

customers to remain solvent. Further, officials at two DFAS Centers raised

concerns that if the amount of cash returned to the Army and Air Force

Fund business areas was not commensurate with their normal operating

needs, they could have a negative cash balance in the near future resulting

in a violation of the Antideficiency Act. In addition, in a November 1994

memorandum to the Principal Deputy Under Secretary of Defense

(Comptroller), the Assistant Secretary of the Navy (Financial

Management) pointed out that the Fund was “not in a healthy financial

condition” and that the Navy would have to determine the cash

requirements of operating their portion of the Fund and the amount of

advance billing necessary to achieve this cash requirement.

Fund Performance

Measures and Goals Still

Being Developed

Performance measurements are a valuable tool for managers because they

provide information on an organization’s operation. Managers can use the

data that performance measures provide to help them account for past

activities, manage current operations, assess progress toward planned

objectives, or better justify budget requests to the Congress and the impact

that budgetary decisions have on an entity’s operations. However,

performance measures and goals are useful as a management tool only if

management makes a commitment that supports their use. One of the

actions in its plan that DOD reported as being complete calls for the DOD

CFO to “re-energize” performance measure development.

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In our March 9, 1994, report,13 we pointed out that DOD had (1) included

performance measures in the Fund’s fiscal year 1994 annual operating

budgets and (2) begun developing the corresponding goals for some

business areas, such as DLA supply management and distribution depots.

However, almost a year later, DOD had developed only 14 goals for the

Fund’s 69 performance measures. For example, for the Navy Fund

business areas, DOD had identified 25 performance measures but had

developed only 4 corresponding goals as of February 1995.

When we discussed the report with DOD officials, they stated that with the

passage of the Government Performance and Results Act of 1993, they

were devoting their efforts to developing performance measures to

accomplish the objectives of the act. DOD also stated that the performance

measures developed for the Fund were “one-liners” and were not

sufficient to meet the criteria set forth in the act. DOD further noted that

one of its pilot programs under the act is the Defense Logistics Agency,

which is a Fund activity.

Conclusions DOD faces formidable challenges in resolving the Fund’s problems.

However, many of these problems, such as inadequate systems, are the

result of years of neglect and date from the old industrial and stock funds.

As we have pointed out and DOD has recognized, the Fund’s financial

systems cannot produce accurate and reliable information on the results

of the Fund’s operations. Until these antiquated systems are eliminated,

(1) the infrastructure costs of maintaining multiple systems for the same

purpose will continue and (2) DOD decisionmakers and the Congress will

continue to receive inaccurate and unreliable information on the Fund’s

results of operation. Also, the recent decision to devolve cash management

abandons one of the goals of the Fund.

Further, DOD can reduce the costs of operations only if it is more

conscious of operating costs and makes fundamental improvements in the

way it conducts business. Although the Fund is to operate on a break-even

basis, it has not been able to meet this financial goal. Fiscal year 1994

marked the third consecutive year of reported losses. If top management

does not place a priority on reversing this trend, the status quo will be

perpetuated and potential savings from the Fund will not be realized.

13Financial Management: Status of the Defense Business Operations Fund (GAO/AIMD-94-80, March 9,

1994).

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B-259833 

Recommendations We recommend that the Congress enact legislation to

• require that the Fund’s prices recover the full costs of using military

personnel in providing goods and service and

• prohibit DOD from including amounts in the Fund’s prices for recovering

prior year losses.

We further recommend that the Under Secretary of Defense (Comptroller)

• ensure that a functional economic analysis is prepared for each of the

recommended Fund interim migratory systems prior to authorizing the

expenditure of funds to enhance and implement the systems;

• reverse the decision to transfer the management of the Fund’s cash to the

military services and DOD components;

• develop a systematic process to ensure the uniform implementation of the

Fund’s policies; and

• revise the revenue recognition policy to require that the percentage of

completion method be used for work done on orders that cross fiscal

years, and clarify the management headquarters policy to specifically

identify the costs to be included in the prices.

We are sending copies of this report to the Secretary of Defense; the

Director of the Office of Management and Budget; the Chairmen and

Ranking Minority Members of the Senate Committee on Governmental

Affairs and the House Committee on Government Reform and Oversight;

and other interested parties. We will make copies available to others upon

request.

Please contact me at (202) 512-6240 if you or your staff have any questions

concerning this report. Other major contributors to this report are listed in

appendix III.

Jack L. Brock

Director, Information Resources

 Management/National Security and

 International Affairs

Page 14 GAO/AIMD-95-79 Fund Management Problems Remain
B-259833 

List of Addressees

The Honorable Strom Thurmond

Chairman

The Honorable Sam Nunn

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 Ronald V. Dellums

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 15 GAO/AIMD-95-79 Fund Management Problems Remain
Contents

Letter 1

Appendix I 

Concerns Regarding

Fund Policies

18

Recovery of Prior Year Losses 18

Revenue Recognition Policy 18

Military Personnel Pricing 19

Economic Analysis for Fund Capital Investments 20

Management Headquarters Costs 20

Appendix II 

Inaccuracies in the

Fund’s Fiscal Year

1994 Monthly

Financial Reports

22

Appendix III 

Major Contributors to

This Report

24

Related GAO Products 28

Abbreviations

CFO Chief Financial Officer

DFAS Defense Finance and Accounting Service

DLA Defense Logistics Agency

DOD Department of Defense

FMR Financial Management Regulation

NPR National Performance Review

Page 16 GAO/AIMD-95-79 Fund Management Problems Remain
Page 17 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix I 

Concerns Regarding Fund Policies

DOD has issued the accounting and financial management policies to

govern the operations of the Fund in the December 1994 DOD Financial

Management Regulation, Volume 11B, Reimbursable Operations, Policy

and Procedures—Defense Business Operations Fund. This is the first time

that the Fund’s policies have been published in a single document.

We disagree with the following five Fund policies: (1) increasing prices

charged customers to recover prior year losses, (2) revenue recognition,

(3) military personnel pricing, (4) mobilization, and (5) economic analysis

for Fund capital investments. We also believe that the policy on

management headquarters costs needs to be clarified.

Recovery of Prior

Year Losses

According to DOD’s pricing policy, prices will be increased to recover

losses. For example, DOD increased fiscal year 1995 Fund prices by

$1.7 billion to recover prior year losses. This policy is inconsistent with the

basic tenet of the Fund—that prices should reflect the actual cost incurred

in providing goods and services. It also diminishes the incentive for the

Fund to operate efficiently and makes it difficult to evaluate and monitor

the Fund’s status.

Charging prices that reflect only the cost expected to be incurred for that

period will enable DOD and the Congress to determine the cost of each

year’s operations and measure the performance of the Fund’s activities for

that period. DOD should be required to justify recovering prior year losses

as part of the appropriation process. The justification should identify why

a business area, such as depot maintenance, incurred a loss. For example,

losses could occur because anticipated savings from productivity

increases were not achieved.

Revenue Recognition

Policy

DOD’s policy standardizes the recognition of revenue throughout DOD by

allowing two methods of recognizing revenue for the depot maintenance

business area:

• The completed order method is used for all orders that have an estimated

value of less than $1 million or a planned production cycle of less than 

1 year.

• The percentage of completion method is used for all orders that have an

estimated value of $1 million or more and a planned production cycle of 

1 year or more.

Page 18 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix I 

Concerns Regarding Fund Policies

Although generally accepted accounting principles recognize both of these

methods, they also specify the different circumstances under which it is

appropriate to use one method or the other. Selecting the appropriate

method is important because operating results reported in an entity’s

financial reports can vary considerably depending upon which method is

used. For example, in 1993 we reported1

 that because Navy industrial fund

activities used the completed contract method for recognizing revenue, the

accumulated operating results at the end of fiscal year 1991 were

understated by about $71 million. This understatement occurred because

the activities deferred recognizing revenue and related expenses until the

work was completed.

In the past, we have supported the use of the percentage of completion

method since income on long-term projects is recognized when the work

is actually performed. In 1991, we reported2

 that the percentage of

completion method is required for long-term projects in order to present

operating results more accurately for the period. Therefore, we believe

that unless the work is completed within the fiscal year in which the order

was accepted, the Fund should account for its revenue under the

percentage of completion method.

Military Personnel

Pricing

Under this policy, the cost of military personnel will be the civilian

equivalent rate, not the military personnel rate. This policy will understate

the total military personnel costs since the civilian equivalency rate is less

than the military personnel cost. DOD estimates about 27,000 military

personnel are working in the Fund’s various business areas during fiscal

year 1995.

One objective of the National Performance Review (NPR) is to include the

full costs in the price that providers, such as the Fund, charge customers

so that the total cost of what the government produces can be determined.

Charging Fund customers the military rate for military personnel, rather

than the civilian equivalent rate, would be more consistent with the full

costing concept of the NPR and with the Fund’s basic intent.

Our concerns about the pricing of military personnel also apply to the

Fund’s mobilization policy. The intent of the Fund is to operate on a

1

Financial Management: Navy Industrial Fund Has Not Recovered Costs (GAO/AFMD-93-18, March 23,

1993).

2

Letter to the Comptroller of Defense (GAO/AFMD-92-5ML, October 22, 1991).

Page 19 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix I 

Concerns Regarding Fund Policies

break-even basis for peacetime operations. However, some Fund activities

incur costs to maintain a mobilization capability for combat situations,

such as the costs to (1) maintain a surge capability and (2) procure and

maintain approved war reserve levels. According to the Fund’s policy,

mobilization efforts are to be funded separately outside the Fund prices

charged customers. While we agree with most of the provisions contained

in the mobilization policy, as discussed above, the military personnel costs

should not be recorded at the civilian equivalency rate.

Economic Analysis

for Fund Capital

Investments

DOD policy requires components to prepare an economic analysis for all

Fund capital investment projects over $100,000. The analysis is to describe

the need for the project, total project costs, and savings expected over the

life of the project. The analysis package for the project selection process

should include

• the net present value, which is the difference between the discounted

present value of benefits and the discounted present value of total costs;

• the “payback” period, which is the time necessary for an alternative to

repay its investment cost; and

• the benefit to investment ratio, which is the total present value of benefits

divided by total present value of costs.

The use of the payback period and the benefit to investment ratio is

contrary to Office of Management and Budget criteria,3

 recent GAO reports,4

and current economic literature that advocates net present value as the

appropriate criterion in choosing between competing investment projects.

Net present value is favored over the other indicators because it more

consistently results in the selection of projects with the greatest benefits,

net of cost. Furthermore, DOD would not need any additional information,

beyond that necessary to calculate payback and benefit-to-investment

ratios, to calculate net present value.

Management

Headquarters Costs

The Fund’s plan required clarification of the existing policy on including

management headquarters costs in the prices the Fund charged its

customers. This policy states that (1) each Fund activity, or group of

activities, is under the management control of a designated DOD

3

U.S. Office of Management and Budget, Circular No. A-94 (revised Oct. 29, 1992).

4

Defense Budget: Capital Asset Projects Undergo Significant Change Between Approval and Execution

(GAO/NSIAD-95-20, December 28, 1994) and Federal Budget: Choosing Public Investment Programs

(GAO/AIMD-93-25, July 1993).

Page 20 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix I 

Concerns Regarding Fund Policies

component, (2) the costs for discrete Fund management headquarters

organizations, and parts of organizations that perform Fund management

headquarters functions, should be financed by the Fund, and

(3) significant costs for common support, such as general counsel and

personnel, used by Fund activities should be allocated to the Fund, if

feasible. Significant management headquarters costs are defined as

exceeding 1 percent of the total business area costs, or $1 million, which

ever is greater.

We agree that management headquarters costs should be included in the

prices the Fund charges customers for the goods and services it provides.

However, we do not believe that the two paragraph policy clarifies which

costs should be included in the Fund for DOD’s complex organizational

structure that includes depots, inventory control points, major commands,

and headquarter components. As a result, the services and DOD

components could interpret the policy differently. Procedures need to be

developed so that this policy can be implemented consistently throughout

DOD.

Page 21 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix II 

Inaccuracies in the Fund’s Fiscal Year 1994

Monthly Financial Reports

Our analysis of the fiscal year 1994 financial reports disclosed numerous

instances in which the reports were inaccurate and, therefore, of

questionable value. Because the Fund’s financial management systems can

neither provide complete and reliable financial data nor report accurately

on the resources entrusted to its managers, the Fund financial reporting

and management at all levels has been impaired. Financial information

requires constant analysis to ensure its validity. However, in many

instances, DOD has allowed obvious erroneous data to remain in the

accounting records, and these data are ultimately included in the Fund’s

financial reports. Some examples follow.

• Significant differences exist between Fund disbursements reported in DOD

Report of Budget Execution (the 1176 report) and those reported by

Treasury. These differences represent disbursements which DOD cannot

allocate to specific business areas or military services. As of September 30,

1994, the difference between the two sets of records was approximately

$528 million. Previously, we reported1

 a similar problem—the difference

between the Fund disbursements reported by DOD and those reported by

Treasury had been $558 million at September 30, 1992.

• The amount of revenue shown on DOD’s monthly 1307 report for the Navy’s

supply management, distribution depots, and logistic support activities

business areas is inaccurate. The inventory prices that the supply

management business area charged customers include the revenue for the

three above business areas, and the revenue amount is not allocated to the

specific business area that earned the money. As a result, the amount of

revenue applicable to the distribution depots and logistic support activities

is not shown on the monthly report of operations, resulting in these two

activities showing a loss.

• On its 1307 report, the Navy shipyard business area showed negative

revenues ranging from $178 million to $902 million for 4 consecutive

months at the beginning of fiscal year 1994. According to DFAS-Cleveland

officials, this occurred because they were required to close the

work-in-process account at the end of fiscal year 1993 and reverse the

entry at the beginning of fiscal year 1994. As a result, the revenue for fiscal

year 1993 was overstated by about $2.3 billion and fiscal year 1994 revenue

was understated by the same amount.

• According to the Air Force’s 1994 fiscal year-end report on supply

management operations, the value of inventories in transit was a negative

$1.7 billion. The Air Force also reported negative balances for inventories

in transit for 4 other months in fiscal year 1994. Since inventories in transit

are items that, for various reasons, are being shipped from one location to

1

Letter to Congressional Committees (GAO/AFMD-93-52R, March 1, 1993).

Page 22 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix II 

Inaccuracies in the Fund’s Fiscal Year 1994

Monthly Financial Reports

another, a negative inventory in transit balance is an abnormal or

misstated account balance indicating that (1) an error was made in

recording inventory data or (2) a problem exists with the procedures used

to account for inventory. DFAS has recognized that it cannot accurately

account for Air Force inventories in transit. To remedy this situation,

DFAS-Denver and the Air Force Audit Agency are working together to

identify and correct the problem.

• On DOD’s monthly management report (the 1302 report), the amount of

Navy supply management accounts receivable and accounts payable at

September 30, 1994, were a negative $336 million and a negative

$625 million, respectively. These accounts normally have positive

balances. According to officials at the DFAS-Cleveland Center, this

occurred, in part, because the balances were reduced for undistributed

collections and disbursements.

Page 23 GAO/AIMD-95-79 Fund Management Problems Remain
Appendix III 

Major Contributors to This Report

Accounting and

Information

Management Division,

Washington, D.C.

Gregory E. Pugnetti, Assistant Director

Darby W. Smith, Assistant Director

Ron L. Tobias, Senior Auditor-in-Charge

William A. Hill, Senior Auditor

Office of the General

Counsel

Douglas H. Hilton, Assistant General Counsel

Page 24 GAO/AIMD-95-79 Fund Management Problems Remain
Page 25 GAO/AIMD-95-79 Fund Management Problems Remain
Page 26 GAO/AIMD-95-79 Fund Management Problems Remain
Page 27 GAO/AIMD-95-79 Fund Management Problems Remain
Related GAO Products

Defense Budget: Capital Asset Projects Undergo Significant Change

Between Approval and Execution (GAO/NSIAD-95-20, December 28, 1994).

Letter to the Principal Deputy Comptroller (GAO/AIMD-94-159R, July 26, 1994).

Defense Business Operations Fund: Improved Pricing Practices and

Financial Reports Are Needed to Set Accurate Prices (GAO/AIMD-94-132,

June 22, 1994).

Financial Management: DOD’s Efforts to Improve Operations of the

Defense Business Operations Fund (GAO/T-AIMD/NSIAD-94-170, April 28, 1994).

Defense Management Initiatives: Limited Progress in Implementing

Management Improvement Initiatives (GAO/T-AIMD-94-105, April 14, 1994).

Financial Management: DOD’s Efforts to Improve Operations of the

Defense Business Operations Fund (GAO/T-AIMD/NSIAD-94-146, March 25,

1994).

Financial Management: Status of the Defense Business Operations Fund

(GAO/AIMD-94-80, March 9, 1994).

Letter to the Deputy Secretary of Defense (GAO/AIMD-94-7R, October 12,

1993).

Financial Management: Opportunities to Strengthen Management of the

Defense Business Operations Fund (GAO/T-AFMD-93-6, June 16, 1993).

Financial Management: Opportunities to Strengthen Management of the

Defense Business Operations Fund (GAO/T-AFMD-93-4, May 13, 1993).

Letter to Congressional Committees (GAO/AFMD-93-52R, March 1, 1993).

Financial Management: Status of the Defense Business Operations Fund

(GAO/AFMD-92-79, June 15, 1992).

Financial Management: Defense Business Operations Fund

Implementation Status (GAO/T-AFMD-92-8, April 30, 1992).

Defense’s Planned Implementation of the $77 Billion Defense Business

Operations Fund (GAO/T-AFMD-91-5, April 30, 1991).

(511289) Page 28 GAO/AIMD-95-79 Fund Management Problems Remain
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