GAO

United States General Accounting Office

Report to the Chairman and Ranking

Minority Member, Subcommittee on

Readiness and Management Support,

Committee on Armed Services,

U.S. Senate

November 2000 DEFENSE

ACQUISITIONS

Prices of Navy

Aviation Spare Parts

Have Increased

GAO-01-23

Page 1 GAO-01-23 Navy Aviation Spare Parts

Contents

Letter 3

Appendixes Appendix I: Scope and Methodology 24

Appendix II: Budgeting and Price-setting Process for

Fiscal Year 2000 29

Appendix III: Federal Supply Groups 30

Appendix IV: Repair Cost Change Distribution 31

Appendix V: Comments From the Department of Defense 32

Appendix VI: GAO Contact and Staff Acknowledgments 36
Page 2 GAO-01-23 Navy Aviation Spare Parts
Page 3 GAO-01-23 Navy Aviation Spare Parts

United States General Accounting Office

Washington, D.C. 20548 Letr

November 6, 2000

The Honorable James M. Inhofe

Chairman

The Honorable Charles S. Robb

Ranking Minority Member

Subcommittee on Readiness and Management Support

Committee on Armed Services

United States Senate

This is the third in a series of reports responding to your request that we

review allegations of significant price increases in Department of Defense

(DOD) weapon system spare parts.1 In particular, some military services

have raised concerns about increases in the prices of spare parts and the

adverse impact escalating prices have had on the readiness of military

forces. In response to these concerns, you requested that we examine

trends in the prices of aviation parts managed by the Navy to (1) determine

whether prices were increasing over time and (2) identify the reasons for

the price increases. In addition, we examined the effect such price changes

were having on customers.

This report focuses specifically on “reparable” spare parts the Navy and the

Marine Corps use to maintain their aircraft and helicopters.2 These parts

are aircraft components that can be economically repaired when they fail

to perform properly. Spare parts are repaired at either military depots or

contractor facilities. Over 90 percent of the time when requisitioning parts,

customers turn in an item that is broken, but that can be repaired, to the

defense logistics system. In 1999, customers spent about $1.7 billion on

these types of requisitions.

Navy spare parts are managed under the Navy Working Capital Fund. This

is a revolving fund that relies on revenues generated from parts and

services sold to customers to finance subsequent operations. It is expected

to generate sufficient revenue to cover the full costs of operations and

operate on a break-even basis over time—that is, not to make a profit or

1

Earlier this year, we issued reports entitled Defense Acquisitions: Prices of Marine Corps

Spare Parts Have Increased (GAO/NSIAD-00-123, July 31, 2000) and Defense Acquisitions:

Price Trends for Defense Logistics Agency’s Weapon System Parts (GAO-01-22,

Nov. 3, 2000).

2 The Marine Corps’ aviation spare parts are managed by the Navy.
Page 4 GAO-01-23 Navy Aviation Spare Parts

incur a loss. Customers order parts from the Navy’s supply system and pay

the working capital fund from their appropriations. The Navy establishes

spare parts’ prices each fiscal year by either increasing or decreasing them

so that they are in line with the customers’ aggregate budgeted amounts.

This concept, in theory, ensures that customers, in the aggregate, have

sufficient funds budgeted to buy their anticipated requirements of spare

parts.

The process for setting prices for parts begins 2 years before the fiscal year

in which prices take effect. Prices are developed to recover estimated costs

for storage, distribution, and other overhead costs incurred in the delivery

of spare parts to customers. To recoup these costs, the Navy adds a

surcharge rate to the latest repair cost of the parts to derive the customer’s

price.3 As part of this process, the Navy also sets an annual price change

rate, that is, an overall percent change in prices that customers can expect

to pay in the upcoming fiscal year. This rate drives customers’ funding, with

the goal of ensuring that customers’ budgets will be sufficient to cover the

cost of the parts they expect to buy.

We analyzed price trends for about 60,000 of the 70,000 spare parts

managed by the Navy from fiscal year 1994 through 1999. We also analyzed

trends for (1) parts that were sold to customers at any point during the

analysis period (about 20,000 items); (2) parts in frequent demand, that is,

those that experienced sales in each of the analysis years (about 5,000

items); and (3) parts unique to select weapon systems. To perform these

analyses, we calculated year-to-year percent changes in customer prices as

well as the annual change in surcharge rates and repair costs. We also

looked at the price change distributions from year to year. We took several

steps to address data quality; however, we did not validate or verify the

pricing data provided by the Naval Inventory Control Point.4 Appendix I

contains detailed information on our scope and methodology.

3 This price is referred to as the net price. The Navy charges customers a higher price,

referred to as a standard price, when a broken part is not turned in or when the customer

procures new parts for initial provisioning. This report focuses on net price trends. “Repair

cost” refers to the price the Navy pays a depot or commercial contractor to repair spare

parts.

4 We recently testified on long-standing problems with DOD’s ability to accumulate and

report on the value of its inventories. Department of Defense: Progress in Financial

Management Reform (GAO/T-AIMD/NSIAD-00-163, May 9, 2000).
Page 5 GAO-01-23 Navy Aviation Spare Parts

Results in Brief Prices for all Navy-managed parts increased at an average annual rate of

12 percent from 1994 to 1999. However, prices for parts with high sales

volume increased substantially more, at an average annual rate of

27 percent. In addition, prices for parts unique to three weapon systems—

the CH-53 Sea Stallion transport helicopter, the F/A-18 Hornet fighter and

attack aircraft, and the AV-8 Harrier attack aircraft—also increased more

significantly than the overall average. Moreover, from year-to-year, there

were very strong fluctuations in prices, indicating substantial price

instability.

Several factors have contributed to price increases. First, the cost of

repairing an item has generally increased over time. Second, the surcharge

that is charged to customers also has increased over time. The surcharge

has also fluctuated dramatically from year to year, driving the instability in

the prices charged to customers. Over 70 percent of the price changes

(increases and decreases) from fiscal year 1994 through 1999 can be

accounted for by surcharge fluctuations. Among other factors, these

fluctuations were caused by DOD’s and the Navy’s attempt to strengthen

the financial viability of the working capital fund, make up for past deficits

and surpluses, and account for savings from efficiency improvements.

The Navy has sought to alleviate customer concerns about high surcharge

rates by moving certain overhead costs from the surcharge to repair costs.

However, this approach merely reallocated the overhead costs, rather than

reducing them. Further, the Navy has not allocated condemnation costs—

that is, the cost to replace items that can no longer be repaired—to the

specific items incurring the costs. Spreading these costs among all items

may hinder managers’ incentives to reduce costs.

Lastly, we found that problems in the price-setting process could cause

problems with customer funding. Specifically, the projected price changes

used to set customer budgets have fallen short of actual price changes.

With sales prices based on assumptions that are made as long as 2 years

before the prices go into effect, some variance between expected and

actual prices is inevitable. Navy officials attributed mismatches between

actual needs and forecasted requirements to unanticipated developments

that occur after the projected overall price change was established, such as

unexpected delays in developing a new weapon system and the availability

of new, but costlier, material for parts. As a result of these discrepancies,

the Navy has found itself in situations where it has had to seek

supplemental appropriations and delay procurements of needed parts.
Page 6 GAO-01-23 Navy Aviation Spare Parts

The Navy has recognized the need to control spare part prices in order to

enhance readiness and plans to further investigate the underlying causes of

the increases. The Navy plans to (1) identify specific reasons for increases

in repair costs (such as labor or material cost increases and differences

with commercial repair costs); (2) examine whether certain weapon

systems are driving repair cost changes at the aggregate level; (3) assess

the effect of increased demand on repair cost; (4) ascertain how changes in

the mix of parts in the inventory over time might lead to repair cost

increases; and (5) determine how individual surcharge elements contribute

to overall surcharge rate changes.

We are making recommendations that build on the Navy’s planned studies

to increase oversight and visibility over efforts to reduce and stabilize spare

part prices and surcharges. In written comments on a draft of this report,

DOD generally agreed with our recommendations and discussed

alternative approaches for viewing price trends.

Background The Navy owns and operates about 4,000 aircraft. When any of the

components on these aircraft fail to perform properly, or reach the end of

their service life, they must be replaced with repaired or newly purchased

parts. There are about 70,000 types of aviation reparable parts. These parts

include airframes and airframe accessory equipment such as landing gear

assemblies, aircraft engines and engine accessory equipment (e.g., fuel

pumps and generators), aircraft instruments, and test equipment. These

components, in turn, are manufactured using thousands of individual

parts.5 Naval aviation depots and commercial contractors perform

maintenance on airframes, engines, and components requiring major

overhaul or modification. In fiscal year 1999, the average price paid by

customers for a repaired part was about $7,000, but it went as high as

$1.4 million per unit. Customers paid less than $5,000 per unit for about

80 percent of the parts.

Pricing spare parts is a 2-year process that involves customers as well as a

number of Navy entities and the Office of the Under Secretary of Defense

(Comptroller). During this process, prices are set based on projected

customer requirements as well as anticipated repair and overhead costs.

5 These include other reparable parts as well as “consumable” parts, i.e., those items that

cannot be cost-effectively repaired. Most consumable parts are managed by the Defense

Logistics Agency.
Page 7 GAO-01-23 Navy Aviation Spare Parts

Appendix II describes the budgeting and price-setting process in greater

detail.

Spare Part Prices Have

Increased With

Dramatic Fluctuations

From Year to Year

Prices for all Navy-managed parts we analyzed increased at an average

annual rate of 12 percent from fiscal year 1994 through 1999. However,

prices for parts actually sold and for parts in frequent demand—that is,

sold every year—increased substantially more. Prices for parts unique to

three weapon systems, which accounted for 34 percent of total sales in

1999, also grew more substantially. Moreover, from year to year there were

very strong fluctuations in prices, indicating considerable price instability.

Spare Part Prices Have

Increased for All Parts

Managed

Prices for all Navy-managed parts—which included about 60,000 items—

increased at an average annual rate of 12 percent from fiscal year 1994

through 1999. Many of these items did not have sales activity during the

analysis period. As noted in table 1, sharp price increases were experienced

in 1995 and 1998.

Table 1: Percent Price Changes—All Navy-managed Parts

Hypothetically, if a part cost $100 in fiscal year 1994, by fiscal year 1999 the

same part would cost $162.

Parts Sold to Customers

Experienced Substantial

Price Growth

Of the approximately 60,000 Navy-managed spare parts included in our

review, 35 percent were sold to customers at least once from fiscal year

1994 through 1999. About 8 percent were in frequent demand, experiencing

sales in each of the 6 years. For each of these two categories of parts, we

calculated the average annual price change and an expenditure-weighted

average annual price change. The latter approach places greater emphasis

on price changes for those parts with higher sales volume.6

Fiscal year

1995 1996 1997 1998 1999

Average annual

change

Annual percent change

in price

32.2 -15.0 9.3 38.1 -4.5 12.0
Page 8 GAO-01-23 Navy Aviation Spare Parts

The first category—parts sold at least once—experienced more substantial

price growth than the overall population of parts, increasing at an average

annual rate of 16.7 percent versus 12 percent. As shown in table 2, parts

with higher sales volume (expenditure-weighted analysis) experienced

even higher price increases, growing at an average annual rate of

22.6 percent. Using the weighted average, a part costing $100 in fiscal year

1994 would cost $258 by fiscal year 1999.

Table 2: Percent Price Changes—Parts Sold

The second category—parts in frequent demand—also experienced more

substantial price increases. As noted in table 3, the average annual price

increase was 19 percent and, when expenditure-weighted, the increase was

27 percent.

6 See app. I for details on expenditure-weighted calculations.

Fiscal year

1995 1996 1997 1998 1999

Average

annual change

Annual price change 46.2 -13.0 11.5 36.5 2.1 16.7

Expenditure-weighted

annual price change 50.2 0.5 9.7 46.0 6.8 22.6
Page 9 GAO-01-23 Navy Aviation Spare Parts

Table 3: Percent Price Changes—Parts in Frequent Demand

Parts Unique to Select

Weapon Systems Have

Experienced Significant

Price Growth

For illustrative purposes, we examined price trends for parts unique to

three aircraft and their engines: the CH-53 Sea Stallion transport helicopter,

the F/A-18 Hornet fighter and attack aircraft, and the AV-8 Harrier attack

aircraft. In fiscal year 1999, over $500 million in revenue—over 30 percent

of total sales—was generated for parts unique to the CH-53 Sea Stallion

transport helicopter and the F/A-18 Hornet fighter and attack aircraft and

their engines. Because Marine Corps officials had expressed concern about

substantial price increases for parts on the AV-8 Harrier attack aircraft, we

also included this aircraft and its engine in the analysis. Parts unique to the

AV-8 Harrier represented about 5 percent of total sales in fiscal year 1999.

As shown in table 4, parts unique to all three aircraft and two of the engines

experienced price increases exceeding the 12-percent annual average for

parts managed. For example, the F/A-18 Hornet and the AV-8 Harrier and

their engines showed price increases about 1.5 times higher than all parts

managed. These increases were driven by substantial price increases in

1995, when prices increased by 68 percent for the F/A-18 Hornet, and in

1998, when prices jumped by 70 percent and more for the AV-8 Harrier and

its engine.

Fiscal year

1995 1996 1997 1998 1999

Average

annual change

Annual price change 50.2 -11.5 13.8 37.5 4.6 18.9

Expenditure-weighted

annual price change

53.3 2.5 20.5 52.0 6.1 26.9
Page 10 GAO-01-23 Navy Aviation Spare Parts

Table 4: Percent Price Changes for Selected Aircraft and Engines

Spare Part Prices Showed

Strong Fluctuations From

Year to Year

While parts’ prices generally increased over the analysis period, there were

also strong fluctuations in price. As shown in figure 1, in 1995 and 1998,

over 85 percent of approximately 60,000 Navy-managed parts showed price

increases exceeding 10 percent while in 1996, prices for 84 percent of parts

managed dropped by 10 percent or more. In any given year, between 3 and

50 percent of the parts showed less than a 10-percent price change. These

extreme price changes from year to year indicate substantial price

instability.

Fiscal year

1995 1996 1997 1998 1999

Average

annual change

AV-8 Harrier 37.5 -18.9 -4.2 70.0 1.4 17.2

Engine (F402) 39.8 -19.4 -5.8 77.8 6.5 19.8

CH-53 Sea Stallion 39.4 -19.4 7.3 41.0 1.1 13.9

Engine (T64) 43.8 -19.8 -9.0 32.9 6.7 10.9

F/A-18 Hornet 68.2 -23.9 5.8 39.5 -1.4 17.6

Engine (F404) 43.5 -20.0 0.2 44.8 9.7 15.6
Page 11 GAO-01-23 Navy Aviation Spare Parts

Figure 1: Distribution of Percent Change in Prices

Surcharge Rate Was

Main Driver of Price

Fluctuations

As noted earlier, the price that customers pay for spare parts is composed

of a repair cost and a surcharge rate. Both components generally increased

over the analysis period. However, on average, over 70 percent of the price

changes (increases and decreases) from fiscal year 1994 through 1999 can

be accounted for by changes in surcharge. In addition, surcharge rates have

fluctuated considerably year-to-year. These fluctuations drove the swings in

customer prices over the 6 years.

Repair Costs and Surcharge

Rates Increased

The repair cost represents the price the Navy pays to naval aviation depots

or commercial contractors to repair parts. This price consists of labor and

0

20

40

60

80

100

1994-95 1995-96 1996-97 1997-98 1998-99

Fiscal year

> -30% Price decrease -10 to -30% -10 to 10% 10 to 30% > 30% Price increase

Percent of parts
Page 12 GAO-01-23 Navy Aviation Spare Parts

overhead costs at the repair facilities, as well as the cost of individual parts

that are used to refurbish the reparable parts. As noted in table 5, repair

costs increased at an average annual rate of 11.8 percent from fiscal year

1995 through 1999. 7

Table 5: Percent Change in Repair Costs

Hypothetically, a part costing $50 in 1994 would cost $86.20 by 1999 based

on these percent changes in costs.

The surcharge rate is applied to an item’s repair cost to recover operating

costs such as

• supply operations support costs (labor, benefits, and supplies);

• condemnation (the cost of replacing parts that can no longer be

repaired);

• shipping and transportation;

• depreciation;

• prior year gains and losses; and

• inflation.

The surcharge rate is derived by dividing the estimated cost of operations

by projected sales. When the cost of operations increases and sales

decrease, increases in the surcharge rate are more dramatic. Figure 2

shows the surcharge rates for 1994 to 1999 and the percent change from

year to year.

7 See app. IV for repair cost change distribution.

Fiscal year

1995 1996 1997 1998 1999

Average annual

change

Annual change in

repair costs

16.7 18.0 -2.1 15.2 11.0 11.8
Page 13 GAO-01-23 Navy Aviation Spare Parts

Figure 2: Surcharge Rates

To provide an illustrative example, if the repair cost of a spare part was

$100, customers would pay $120 based on the 1994 surcharge rate of

20.2 percent. Assuming the repair cost remained the same, customers

would have paid $136 for the part at the higher 1995 surcharge rate of

36.2 percent. As shown in figure 2, surcharge rates increased from the 1994

rate in every year except 1996.

Surcharge Fluctuations

Drove Price Changes

Surcharge rates fluctuated dramatically over the analysis period, as shown

in figure 2. For instance, the surcharge rate increased by 91 percent in 1998,

but dropped by 40 percent in the following year. We compared the year-toyear dollar change in repair costs and surcharge amounts as a proportion of

the dollar change in customer prices8 and found that changes in surcharge

20.2

36.2

14.5

28.0

53.5

32.1

1994 1995 1996 1997 1998 1999

Percent change in surcharge rate:

79% -60% 93% 91% -40%

8 See app. I for methodology.
Page 14 GAO-01-23 Navy Aviation Spare Parts

amounts accounted for a larger portion of the price fluctuations (increases

and decreases). On average, over the analysis period, 73 percent of the

dollar change in prices was attributable to changes in the surcharge

amount.

Several Factors Contributed

to Surcharge Fluctuations

One reason that surcharges increased substantially in fiscal years 1995 and

1998 was that the Office of the Under Secretary of Defense (Comptroller)

directed the Navy to recoup $375 million and $167 million, respectively, to

improve the financial viability of the working capital fund. These funds

were recouped by increasing the surcharge rate.

Another reason for the surcharge fluctuations was adjustments for prior

year accumulated gains and losses.9 Defense regulations require the

military services to use accumulated operating results in determining the

prices to charge customers, with the goal of operating the supply fund on a

break-even basis over time. Large swings in the accumulated operating

result indicate that, from fiscal year 1994 through 1999, the Navy ran a

surplus in some years and large deficits in other years. In a surplus

situation, the surcharge rate is lowered; in a deficit situation, the rate is

increased.

A third reason for the surcharge fluctuations was surcharge reductions

made from 1995 through 1997. These reductions were implemented to

capture savings anticipated from more efficient operations under the

working capital fund. Although the surcharge was lowered in 1996 and

1997, the savings ended in 1998, contributing to the increased rate that year.

A fourth reason for the fluctuations was that the Navy’s sales base declined

in 1998. This drop in sales contributed to the high surcharge rate that year.

According to Navy documents, this was largely due to a DOD program that

required the military services to transfer responsibility for most

consumable spare parts to the Defense Logistics Agency.

Navy Shifted Costs Out of

Surcharge Rate

According to officials at the Office of the Secretary of Defense and the

Navy, increases in the surcharge have become a significant concern among

operating units. The high surcharge rate in 1998, in particular, caused an

9 This difference between revenue and expenses over a period of time longer than a year is

referred to as the accumulated operating result.
Page 15 GAO-01-23 Navy Aviation Spare Parts

avalanche of customer complaints. In an effort to reduce the surcharge rate

and respond to customer complaints, the Navy shifted costs related to

transportation, condemnation, and obsolescence (the reduced value of

assets whose use is precluded by a change in technology or operations)

from the surcharge rate to repair costs.

In fiscal year 1999, the first year that transportation costs were removed

from the surcharge rate, about $100 million was shifted and spread across

repair costs. In 2000, about $200 million in condemnation and obsolescence

costs were applied to repair costs. According to Navy budget documents,

the initiative to remove these costs from the surcharge rate preserves the

basic tenet of full cost recovery under the working capital fund, while not

changing the customer price. In fact, the Navy stated that applying

transportation costs to repair costs better reflects the cost of goods sold

and standard industry practice. The Navy also stated that the transfer of

condemnation and obsolescence costs was done to be consistent with

other services.

However, shifting these elements out of the surcharge rate to the repair

costs did not reduce the Navy’s overhead costs; it transferred them to a

different category. While in theory the customer’s price remains the same,

this change masks the cost of supply operations by making it appear that

the overhead costs have dropped, when in reality they have merely been

reallocated. In addition, condemnation costs (the cost of procuring new

items to replace those that can no longer be repaired) are spread across all

spare parts, rather than being allocated to the specific parts or groups of

parts being replaced.10 As a result, all customers are paying for these costs,

regardless of whether they are buying the parts that incur condemnation

charges. In addition, because these costs are spread across all spare parts,

they are not reflected in the specific parts that are condemned. As such,

this action may actually reduce the incentive for managers to cut costs for

certain items.

10The Air Force applies condemnation costs to the groups of spare parts actually incurring

the costs. See Air Force Supply Management: Analysis of Activity Group’s Financial Reports,

Prices, and Cash Management (GAO/AIMD/NSIAD-98-118, June 8, 1998).
Page 16 GAO-01-23 Navy Aviation Spare Parts

Inaccurate Price

Change Projections

Can Lead to Customer

Funding Shortfalls

As part of the price-setting process, the Navy and DOD project an overall

percent change in prices that customers can expect to pay in the next

budget year. Since customers’ budgets are based on this number, it is

critical that it be accurate and in line with the actual prices that are

eventually set for individual items. In recent years, however, there have

been discrepancies between projected and actual prices. Unanticipated

developments, such as the availability of new, costlier material, can result

in a mismatch between forecasted requirements and actual needs. These

differences, in turn, can cause customers to seek supplemental

appropriations or delay procurement of the parts they need.

Customer Budgets Are

Based on Projected Price

Changes

The projected price change, which the Navy refers to as the annual price

change rate, is the means of ensuring that customers’ budgets are balanced,

in the aggregate, with the prices of the spare parts they plan to buy. As

mentioned earlier, the process of setting this projection, which is subject to

approval from the Office of the Under Secretary of Defense (Comptroller),

begins 2 years prior to the start of a fiscal year.11 If actual prices are set

higher than the projected level, customers may not have sufficient funds to

buy the items they need. When funding falls short, customers must

(1) reprogram and/or transfer funds from other accounts, (2) seek

supplemental appropriations, or (3) delay procurement of the parts they

need.

The following examples further illustrate how customer funding—at the

command, activity, and field unit level—is tied to the projected price

change.

• In fiscal year 1998, spare part prices, which became effective on October

1, 1997, in a process that began in the summer of 1996, were expected to

increase by 24.7 percent. This projected increase meant that Navy

customers, as a whole, would have to increase their spare parts budget

by 24.7 percent from 1997 funding levels to sufficiently cover spending

requirements for spares.

• After the aggregate projected rate was established, the Naval Inventory

Control Point provided Navy commands with projected price changes

by weapon system. This information is provided each year to help

activities distribute their funding so that field units will have the funds

11 See app. II for a time line depicting the 2-year process.
Page 17 GAO-01-23 Navy Aviation Spare Parts

they need to buy the parts for which they projected a requirement in the

budget process. Factors such as projected demand, repair cycles, and

system modifications affect the rate at the weapon system level.

• For some weapon systems, the projected price change can be

significantly higher than for others. For example, in the aggregate,

prices were expected to increase by 24.7 percent in 1998. However, the

projected price change for parts unique to the S3 Viking aircraft was

15.5 percent, while the price change for its engine, the TF 34, was

70.9 percent.

Over the past several years, the overall projected price change has

fluctuated considerably. As shown in table 6, projected price changes were

highest in fiscal years 1995 and 1998. In fiscal years 1999 and 2000,

projected price changes were more moderate. However, in fiscal year 2001,

the projected price change again increased significantly. This was partly

due to a modeling error that was made in setting the 1999 price change rate.

Specifically, transportation costs were not captured and material escalation

costs were understated, resulting in a deficit for the working capital fund.

Collection of these costs began in fiscal year 2001, causing the annual price

change rate to increase to 14.3 percent for that year.

Table 6: Navy’s Projected Annual Price Changes

Unanticipated

Developments Can Cause a

Mismatch Between Actual

and Projected Prices

We compared actual price changes with the Navy’s projected price changes

from fiscal years 1994 through 1999 and found that the Navy’s projected

changes fell short of actual price changes in 4 of the 5 years, as shown in

figure 3. Again, because customer funding is tied to the projected change,

such discrepancies can lead to funding shortfalls and possibly affect

readiness.

Fiscal year

1994 1995 1996 1997 1998 1999 2000 2001

Projected annual price

changes (percent)

6.3 28.3 -21.6 5.7 24.7 -3.6 -2.9 14.3
Page 18 GAO-01-23 Navy Aviation Spare Parts

Figure 3: Projected Price Change Rate Compared to Actual Price Change

With sales prices based on assumptions that are made as long as 2 years

before the prices go into effect, some variance between expected and

actual costs is inevitable. Weapon system managers and other Navy

officials noted that unanticipated developments can result in a mismatch

between actual needs and forecasted requirements. For example:

• DOD may initiate logistics engineering changes that call for replacing

selected items with more reliable or easily maintained substitutes.

These modifications, while initially costly, are intended to improve the

performance and value of the weapon system from a total life-cycle

perspective. However, the Navy has found that implementing such

changes has cost more than originally anticipated. According to a Navy

document, customers have had insufficient resources allotted in the

budget process to pay for the new, improved items.

• Unexpected delays in developing a new system may occur. The annual

price change is based on the forecasted availability of the system, but if

-30

-20

-10

0

10

20

30

40

50

1995 1996 1997 1998 1999

Actual price change Projected price change

In percent
Page 19 GAO-01-23 Navy Aviation Spare Parts

it is not ready when projected, the Navy must continue to pay higher

costs to maintain the old system that it is replacing.

• New and improved material is available, but its cost was not built into

the projections established 2 years prior. Thus, customers have

insufficient funds to pay for the material. For example, during the pricesetting process for fiscal year 1998, the Navy estimated that it would

require modifications to a high-pressure turbine rotor—a major

component of the F 402 engine on the AV-8B aircraft. However, it did not

anticipate having to replace all of the blades on the rotor with new

material, a situation that occurred because the old and new materials

could not be intermingled on the rotor. This unexpected extra work and

the cost of new material for all of the blades drove up the price of the

rotor from an estimated price of $30,350 to an actual price of $853,890—

a 2,713-percent increase. Because the higher price was not reflected in

the projected 1998 annual price change rate, the Navy fleet’s budget had

not been adjusted to cover the repair costs. Thus, the Navy Working

Capital Fund absorbed the cost so as not to adversely affect the fleet’s

budgets. In 1999, the customers’ price reflected the higher cost.

Customers can experience funding problems when forecasted budgetary

needs are inaccurate. According to DOD officials, funding in 1997 was

insufficient because flying hour projections were too low. These inaccurate

estimates, in turn, resulted in an understated projected price change and

underfunded customer budgets. As a result, customers lacked the funds

necessary to pay for aircraft spare parts, and the Navy could not collect

sufficient revenue to pay for the spare parts their customers needed. To

address this problem, the Navy allocated $116 million of a fiscal year 1999

supplemental appropriation to purchase aviation spare parts. These funds

were used to buy parts that had been deferred in 1997 and to reduce

subsequent backlogs in repair work.

Navy Studies Focus on

Pricing-Related

Problems

The Navy has recognized that increasing and unstable prices can affect

readiness and has conducted studies to determine the causes of the price

increases and recommend improvements. A 1998 report on Naval Aviation

Maintenance and Supply Readiness identified price increases for aviation

spares as a key concern that could affect readiness. The Navy has identified

100 specific parts as cost drivers—those with the highest price increases

and the most demand. The report noted that decreasing the cost and/or

improving the reliability of these components would significantly enhance

readiness. The report also stated that difficulties in accurately projecting

flying hour costs has led to underfunding, which, in turn, could have caused
Page 20 GAO-01-23 Navy Aviation Spare Parts

a decline in readiness. The report concluded that improving the accuracy of

budget forecasting would help address this problem.

According to a recent study update, engineering and design changes and

other modifications have increased the reliability and stability of prices for

several of the items. However, current price trends were expected to

continue for other items. The Navy also noted that gathering detailed

demand and repair cost data at the item level is a very labor-intensive

process.

In October 1999, the Deputy Chief of Naval Operations (Logistics) directed

a study group to review aviation repair pricing processes, determine the

extent of pricing problems, and recommend corrective actions. Further, in

a July 2000 report, the Center for Naval Analyses found that aviation spare

part costs have grown rapidly since the early 1990s. The Center is

undertaking a series of follow-on studies that include assessing

• the effect of certain weapon systems on cost changes at the aggregate

level,

• the impact of increased demand on cost,

• the effect of changes in the mix of parts in the inventory over time on

cost increases,

• the differences between commercial and naval aviation depot repair

costs for similar items,

• the price impact of the “consumable” material—that is, parts that are

consumed in use—on aviation spares part costs, and

• the effect of changes in the surcharge elements on overall surcharge

change.

Conclusions Aviation spare parts prices—especially those in frequent demand—have

experienced substantial increases. Moreover, there were dramatic price

fluctuations from year to year, largely due to surcharge rate changes. The

Navy’s plans to further study the underlying causes of price increases

appropriately focus on answering questions such as what are the reasons

behind repair cost increases, which weapon systems drive aggregate cost

changes, what effect does increased demand have on prices, and what

elements are driving surcharge rate changes. Nevertheless, it will be

important for DOD to ensure that the Navy follows through on the study

results by identifying and implementing appropriate corrective actions. In

addition, the Navy has sought to alleviate customer concerns about high

surcharge rates by moving certain overhead costs from the surcharge to
Page 21 GAO-01-23 Navy Aviation Spare Parts

repair costs. However, this approach merely reallocated the overhead

costs, rather than reducing them. Also, condemnation costs, now part of

the repair costs, continue to be spread among all spares rather than

allocated at the item level, potentially reducing managers’ incentive for

controlling these costs.

Recommendations for

Executive Action

We recommend that the Secretary of Defense ensure that the Navy follows

through on the results of its planned studies by identifying and

implementing solutions to reduce and stabilize prices and surcharge rates.

We also recommend that the Secretary of Defense direct the Navy to

allocate condemnation costs to the specific parts or groups of parts

incurring the costs. If this allocation cannot be achieved, we recommend

that condemnation costs be reflected in the surcharge rate. Finally, we

recommend that the Secretary of Defense report to the Congress on the

Navy’s progress in (1) reducing and stabilizing prices and surcharge rates

and (2) allocating condemnation costs at the item level.

Agency Comments and

Our Evaluation

In written comments on a draft of this report, DOD generally agreed with

our principal findings and recommendations. DOD noted that certain

approaches to cost analysis, such as studies of unit cost trends (the subject

of this report) or cost per flight hour (the subject of recent studies by the

Center for Naval Analyses), may overlook reliability improvements that are

intended to reduce total costs. We do not disagree with this assertion.

However, we believe it is important to continue to track unit price

increases as part of assessments regarding the effectiveness and efficiency

of reliability improvements.

DOD agreed with our recommendation that the Department carry out

planned studies concerning the reduction and stabilization of prices and

the surcharge rate. The agency, however, asserted that our report implies

that the surcharge rate is the primary driver of price escalation. This

statement is incorrect. Our report states that the surcharge rate was the

primary driver of price fluctuation (both increases and decreases), not

price escalation alone.

Regarding our recommendation to allocate condemnation costs to the

specific parts or groups of parts incurring the costs, DOD stated that it had

begun to allocate these costs beginning in fiscal year 2001. DOD plans to

refine its cost allocation methodology to raise the level of attention on
Page 22 GAO-01-23 Navy Aviation Spare Parts

items with low survival rates and drive reliability improvements where

possible.

DOD agreed to report to Congress, using traditional means such as the

President’s budget submission. We believe that the President’s budget

submission would be a reasonable vehicle for reporting to Congress on the

results of the Navy’s ongoing studies and on the Department’s progress in

reducing and stabilizing prices and surcharge rates. However, if this

mechanism is used, these topics should be highlighted in a separate section

and discussed in detail.

The Department’s comments appear in appendix V.

We are sending copies of this report to the appropriate congressional

committees; the Honorable William S. Cohen, Secretary of Defense; the

Honorable Richard Danzig, Secretary of the Navy; General James L. Jones,

Commandant of the Marine Corps; and the Honorable Jacob J. Lew,

Director, Office of Management and Budget.

GAO contacts and major contributors to this report are listed in

appendix VI.

David E. Cooper, Director

Acquisition and Sourcing Management
Page 23 GAO-01-23 Navy Aviation Spare Parts
Page 24 GAO-01-23 Navy Aviation Spare Parts

Appendix I

Scope and Methodology ApApenednxidexiIs

To evaluate trends in Navy aviation spare part prices, we obtained repair,

net, standard, and procurement price data for the approximately 70,000

Navy-managed depot level aviation reparables from the Naval Inventory

Control Point-Philadelphia. This information was obtained from the Navy’s

Master Item File−a database containing reparable prices and other

technical data. The Naval Inventory Control Point also provided us with

billing records extracted from the Billing History File. Furthermore, we

collected information about the aviation reparable budgeting and pricing

cycle and reviewed Department of Defense (DOD) and Navy financial

management and budget regulations and our reports.

We did not request data on the consumable spare parts that are still under

the Navy’s purview because we conducted a separate review of the Defense

Logistics Agency’s consumable spare part prices. About 95 percent of

consumable spares are now managed by the Defense Logistics Agency.

We did not validate or verify the pricing data the Naval Inventory Control

Point provided. However, we took several steps to address data quality.

Specifically, we reviewed the data and performed various quality checks,

which revealed some discrepancies in the data. We discussed these

discrepancies with Inventory Control Point officials and where appropriate

deleted the data from our analysis universe.

Analysis Universe Customers are charged the net price when they turn in a broken item to be

repaired; otherwise they pay the higher, standard price. Because over 90

percent of the time customers pay the net price, we focused our analysis on

this price. We excluded parts that did not have a National Item

Identification Number (these parts have not been catalogued). These parts

are classified as bachelors, family heads, or family members. 1 We limited

our price trend analysis to bachelors and family heads in a particular year

and excluded family members.

Preliminary percent change distributions revealed a small number of

extreme price changes. Between fiscal year 1995 and 1999, about 99

percent of the parts experienced price changes under 500 percent.

However, approximately 1 percent showed price changes from 500 percent

1 Parts in the same family have a similar form, fit, and function. Prices for head and member

parts in the same family are based on the repair cost resident with the family head, plus the

surcharge rate.
Appendix I

Scope and Methodology

Page 25 GAO-01-23 Navy Aviation Spare Parts

to over 100,000 percent. Because these extreme values skewed our average

annual price change, we set aside parts in the 1-percent tail ends of the

percent change distribution from our price trend analysis. Table 7 shows

the average price change with and without extreme values.

Table 7: Average Price Change With and Without Extreme Values

After applying these filters, our analysis universe included about 51,000 to

52,000 of the approximately 70,000 Navy-managed spare parts in any given

year. Over the analysis period, we examined about 60,000 parts. Since some

spare parts have been removed or introduced to the Navy’s inventory over

time, these 60,000 spare parts do not represent a market basket. All

findings in this report are based on these modifications.

Price Trend Analysis To assess whether spare parts’ prices have increased, decreased, or

remained the same over time, we calculated the year-to-year percentage

change in prices for each of the approximately 60,000 parts and the average

annual price change for each year. We also looked at the price change

distributions. Because the price change distributions varied drastically

from year to year, we chose the 10-percent change as a benchmark of

relative price stability. Although we did not identify a comparable indicator

to assess price changes in aviation spares, we used as a proxy the Bureau

of Labor Statistics’ Producer Price Index commodity group “Intermediate

Materials, Supplies, and Components/Materials and Components for

Manufacturing.” Between 1994 and 1999, prices for materials used in the

production of goods in this index changed between −0.2 and 1.6 percent

and averaged 0.3 percent over this period.

Fiscal year

1995 1996 1997 1998 1999

Average

annual change

Percent price change (all

parts)

48.8 11.7 23.5 54.0 108.6

49.3

Percent price change

(removed

1-percent tail ends)

32.2 -15.0 9.3 38.1 -4.5 12.0
Appendix I

Scope and Methodology

Page 26 GAO-01-23 Navy Aviation Spare Parts

Parts sold to customers We used billing records to identify spare parts sold to customers and the

dollar value of total sales.2 The Naval Inventory Control Point sold

approximately 10,000 to 12,000 types of spare parts each year.3 Since

customers buy different types of spare parts from year to year, we do not

have a market basket of spares. Over the analysis period, customers bought

about 21,000 different types of parts (35 percent of the parts examined). We

calculated the average annual percent change in prices and expenditureweighted average annual percent change in prices for this subset of parts.

Under this latter approach, parts with higher sales received larger weights

and greater emphasis. Weights were calculated by dividing total sales for

each spare part into total sales for a given year. These weights were applied

to percent changes for parts sold to determine the expenditure-weighted

price changes. In addition to parts sold, we calculated the average annual

percent change and the expenditure-weighted average annual percent

change for frequent-demand parts − those sold in all 6 years of our analysis

period. There were about 5,000 frequent-demand parts.

Aircraft and federal supply

groups

We calculated the annual average price change for various subsets of parts

by selecting parts unique to the F/A-18 Hornet, the CH-53 Sea Stallion, the

AV-8 Harrier, and their engines (F404, T64, and F402). To identify these

parts, we used weapon system codes. We also examined price trends for

the five federal supply groups that had the highest sales in fiscal year 1999.

To identify these groups of parts, we used the federal supply group, a

component of each part’s national stock number.

Analysis of Repair Costs and

Surcharge Contributions to

Price Change

The price that customers pay for spare parts is repair cost plus the

surcharge amount. Theoretically, the change in repair cost plus the change

in surcharge amount equals the new price. To determine how much the

repair component and the surcharge component were contributing to price

trends, we calculated the change in repair costs and the change in

surcharge amount as a proportion of the change in price (increases and

decreases). Table 8 is an example of the calculation used.

2 See section on billing transaction analysis for more information about transactions

retained for this analysis.

3 We limited parts sold to bachelors and family heads.
Appendix I

Scope and Methodology

Page 27 GAO-01-23 Navy Aviation Spare Parts

Table 8: Example of Calculation Used to Determine Percentage of Price Change

Attributable to Repair Versus Surcharge

a

Dollar change is the price in the current year subtracted from the prior year.

b

The percentage of change attributable to repair is the change in repair divided by the change in price

and then multiplied by 100.

We did not examine the direction of change, that is, whether prices

increased or decreased. Our primary interest was to determine which

component had a larger effect on the observed price fluctuations. This

calculation was performed for the approximately 60,000 parts that were

bachelors and family heads.

Billing Transactions

Analysis

We used the Navy’s Billing History File to identify parts sold to customers

and total sales for parts sold. We performed several data checks and

excluded transactions from the billing data that met the following criteria.

• Transactions for consumable parts.

• Transactions that did not have a National Item Identification Number

(customers normally are not billed for these parts).

• Transactions where customers were charged a price that did not appear

in the Master Item File in any of the 6 years.

• Transactions, which totaled about $100 million in 1998, that had been

mistakenly coded as standard sales rather than net sales due to a

computing error. We moved this $100 million into our fiscal year 1998

net sales.

Fiscal year

Servocylinder

(part unique to the

F/A-18 Hornet) 1994 1995 1996 1997 1998 1999

Repair component $5,380 $5,483 $4,846 $5,929 $6,917 $6,108

Surcharge component 1,090 1,987 704 1,661 3,703 1,962

Price $6,470 $7,470 $5,550 $7,590 $10,620 $8,070

Dollar change in repaira $103 ($637) $1,083 $988 ($809)

Dollar change in surcharge 897 (1,283) 957 2,042 (1,741)

Dollar change in price $1,000 ($1,920) $2,040 $3,030 ($2,550)

Percent of price change

attributable to repairb

10 33 53 33 32

Percent of price change

attributable to surcharge

90 67 47 67 68
Appendix I

Scope and Methodology

Page 28 GAO-01-23 Navy Aviation Spare Parts

• Transactions for family member parts.

• Transactions where sales summed to a negative number (i.e., credits

exceeded bills for a requisition in a given year).

All analyses requiring billing information were based on this modified

database.

Reasons for Surcharge

Fluctuations

To determine possible reasons for changes in the surcharge rate, we

reviewed financial management regulations, the Navy’s budget guidance,

and Working Capital Fund budget estimate justifications. We also

interviewed Office of the Under Secretary of Defense (Comptroller) and

Navy officials. We used price data to verify that surcharge rates were

consistently applied.

We performed our review at the Office of the Under Secretary of Defense

(Comptroller)/Revolving Fund Directorate, Washington, D.C.; the Under

Secretary of Defense (Comptroller)/Program Analysis and Evaluation,

Washington, D.C.; the Navy/Financial Management and Comptroller,

Crystal City, Virginia; the Chief of Naval Operations/Air Warfare Division,

Washington, D.C.; the Naval Supply Systems Command, Mechanicsburg,

Pennsylvania; the Naval Inventory Control Point-Philadelphia,

Pennsylvania; the Naval Aviation Depot, Cherry Point, North Carolina; and

the 2nd Marine Air Wing, Cherry Point, North Carolina. We conducted our

review from February 1999 through August 2000 in accordance with

generally accepted government auditing standards.
Page 29 GAO-01-23 Navy Aviation Spare Parts

Appendix II

Budgeting and Price-setting Process for Fiscal

Year 2000 ApendxiI

NAVSUP

Proposes surcharge rate and annual

price change rate

6/98

OSD/C

Reviews price change rate

Fleet

Prepares FY 2000 budget using

price change rate

2/99

10/98 FY 1999 begins

FY 1999 prices executed

NAVICP

Sets new prices based on updated

demand and repair and

procurement costs

Adjusts surcharge rate to achieve

approved annual price change rate

Proposes final surcharge rate

10/99 FY 2000 begins

FY 2000 prices executed

NAVSUP

Approves final surcharge rate

NAVY/FMB

Adjusts annual price change rate to

balance with customer budgets

6/99

Agencies submit initial

FY 2000 request to OMB

President submits FY 2000

budget proposal to the

Congress

Appropriations hearings

begin

Congress completes action

on appropriations bills

NAVSUP

NAVICP

Sends sales projections for FY 2000 Fleet

Submits

projected

budget for

FY 2000

Approves rate

Sends estimated

surcharge rate

and approved

price change rate

9/98

4/99

8/99

9/99

NAVICP - Naval Inventory Control Point

NAVSUP - Naval Supply Systems Command

NAVY/FMB - Navy Financial Management and Comptroller

NAVICP

Issues price change rate by weapon system

Fleet

OSD/C - Office of the Under Secretary of Defense (Comptroller)

OMB - Office of Management and Budget

Submits

updated

requirements
Page 30 GAO-01-23 Navy Aviation Spare Parts

Appendix III

Federal Supply Groups ApendxiI

The Department of Defense uses a two-digit federal supply group code to

categorize and manage its spare parts, in addition to a unique nine-digit

national item identification number. Table 9 summarizes the average annual

price change for the five supply groups with the highest sales.

Table 9: Annual Percent Change in Prices by Federal Supply Group

Fiscal year

1995 1996 1997 1998 1999

Average

annual

change

Electrical and electronic equipment

components

31.7 -20.3 7.9 33.9 -5.7 9.5

Communication, detection, and

coherent radiation equipment

33.9 -13.9 7.3 35.5 -5.1 11.5

Instruments and laboratory equipment 31.1 -12.9 9.7 39.7 -4.0 12.7

Aircraft components and accessories 37.0 -12.0 9.9 43.7 -1.6 15.4

Engine, turbines, and components 29.0 -5.4 16.6 41.9 -4.9 15.4

All other federal supply groups 31.0 -13.0 10.7 41.1 -3.9 13.2
Page 31 GAO-01-23 Navy Aviation Spare Parts

Appendix IV

Repair Cost Change Distribution ApendxiIV

Note: Repair cost is one component of the customer’s price.

0

20

40

60

80

100

1994-95 1995-96 1996-97 1997-98 1998-99

Fiscal year

> -30% Price decrease -10 to -30% -10 to 10% 10 to 30% > 30% Price increase

Percent of parts
Page 32 GAO-01-23 Navy Aviation Spare Parts

Appendix V

Comments From the Department of Defense ApendxiV
Appendix V

Comments From the Department of Defense

Page 33 GAO-01-23 Navy Aviation Spare Parts
Appendix V

Comments From the Department of Defense

Page 34 GAO-01-23 Navy Aviation Spare Parts
Appendix V

Comments From the Department of Defense

Page 35 GAO-01-23 Navy Aviation Spare Parts
Page 36 GAO-01-23 Navy Aviation Spare Parts

Appendix VI

GAO Contact and Staff Acknowledgments ApendxiVI

GAO Contact Karen S. Zuckerstein (202) 512-6785

Acknowledgments In addition to those named above, Michele Mackin, Yeewan Tom, and

Charles Perdue made key contributions to this report. Gregory E. Pugnetti

served as advisor.

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