United States General Accounting Office

GAO Report to the Chairman of the

Subcommittee on Military Readiness,

Committee on National Security,

House of Representatives

March 1997 NAVY ORDNANCE

Analysis of Business

Area Price Increases

and Financial Losses

GAO/AIMD/NSIAD-97-74

GAO United States

General Accounting Office

Washington, D.C. 20548

Accounting and Information

Management Division

B-274841 

March 14, 1997

The Honorable Herbert H. Bateman

Chairman, Subcommittee on Military Readiness

Committee on National Security

House of Representatives

Dear Mr. Chairman:

This report responds to your request that we review financial and operational management

issues relating to the Navy ordnance business area which was included in the Defense Business

Operations Fund (DBOF). On December 11, 1996, the Under Secretary of Defense (Comptroller)

reorganized DBOF and created four working capital funds: Army, Navy, Air Force, and

Defense-wide. The Navy ordnance business area is now part of the Navy Working Capital Fund.

The four working capital funds will continue to operate under the revolving fund concept and

charge customers the full costs of providing goods and services to them. Since the Navy

ordnance business area still operates under the revolving fund concept, our findings and

recommendations are applicable under the working capital fund structure.

The financial information on the operation of this business area shows that there are several

key reasons for about $212 million of reported losses experienced from fiscal year 1994 through

fiscal year 1996. In particular, most of these losses were attributable to actual overhead costs

exceeding budgeted overhead costs. This situation has caused significant price increases that

ultimately result in reduced purchasing power for the military services’ operations and

maintenance appropriation dollars. We are concerned that excessive operating costs may exist

in many of the Department of Defense’s (DOD) logistics business activities and may be causing

substantial amounts of operation and maintenance appropriations to be used inefficiently. As

discussed with your office, we will be looking at additional DOD business activities to determine

the extent of this problem.

We are sending copies of this report to the Ranking Minority Member of your Subcommittee;

the Chairmen and Ranking Minority Members of the Senate Committee on Armed Services; the

Senate Committee on Appropriations, Subcommittee on Defense; the House Committee on

Appropriations, Subcommittee on National Security; the Senate and House Committees on the

Budget; the Secretary of Defense; the Secretary of the Navy; and the Director of the Defense

Finance and Accounting Service. Copies will also be made available to others upon request.
B-274841 

If you have any questions about this report, please call Greg Pugnetti at (202) 512-6240. Other

major contributors to this report are listed in appendix II.

Sincerely yours,

Jack L. Brock, Jr.

Director, Defense Information and

 Financial Management Systems

Accounting and Information

 Management Division

David R. Warren

Director, Defense Management

National Security and International

 Affairs Division

Page 2 GAO/AIMD/NSIAD-97-74 Navy Ordnance
B-274841 

Page 3 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary

Purpose The Chairman, Subcommittee on Military Readiness, House Committee on

National Security, asked us to determine why the Navy ordnance business

area increased prices 78 percent from fiscal years 1994 through 1996 and

incurred about $212 million in losses during that 3-year period. The

Chairman also asked us to determine whether management has accurate

and consistent financial management information for effectively managing

the Navy ordnance business area.

On December 11, 1996, the Under Secretary of Defense (Comptroller)

reorganized DBOF and created four working capital funds: Army, Navy, Air

Force, and Defense-wide. The Navy ordnance business area is now part of

the Navy Working Capital Fund. The four working capital funds will

continue to operate under the revolving fund concept—using the same

policies, procedures, and systems as they did under DBOF—and charge

customers the full costs of providing goods and services to them. The

Comptroller made this change to clearly establish the military services’

and DOD components’ responsibilities for managing the functional and

financial aspects of the business areas.

Background The Navy ordnance business area provides various services, including

ammunition storage and distribution as well as the maintenance of

missiles, to customers who consist primarily of Defense organizations but

also include foreign governments. During fiscal year 1996, the business

area sold about $563 million of services to its customers—primarily

commands and activities of the military services. For financing purposes,

the business area is part of the Navy Working Capital Fund, which is a

revolving fund that relies on sales revenue rather than direct congressional

appropriations to finance its operations. Revolving funds are supposed to

generate sufficient revenues to cover the expenses incurred in their

operations. In fact, the revolving funds are expected to operate on a

break-even basis over time—that is, not to make a profit nor incur a loss,

but simply to recover all costs.

The Navy ordnance business area generates revenue by billing customers

at predetermined prices as it performs specifically agreed upon work for

those customers. The prices are to be based upon anticipated actual costs.

Customers primarily use operations and maintenance appropriations to

pay for this work. Payments from customers replenish the Navy Working

Capital Fund’s working capital, which is used to finance subsequent

operations. The ordnance business area is expected to operate within the

revenue it generates. Conceptually, this provides an incentive to control

Page 4 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary

costs and maximize efficiency. It is essential that the business area operate

efficiently since every dollar spent on the Navy Working Capital Fund’s

infrastructure is one less dollar available for other defense spending

priorities.

Results in Brief The business area’s price increased from $50.02 per direct labor hour in

fiscal year 1994 to $89.03 per direct labor hour in fiscal year 1996—a 78

percent increase. A large part of this price increase was due to the

inclusion of significant overhead costs in the prices charged

customers—costs that were previously paid for through direct

appropriations or by Navy major commands. Even though the prices

increased, the business area reported it lost about $212 million during

fiscal years 1994 through 1996, and would have lost more if it had not been

allowed to increase its prices in order to recoup prior year losses. These

losses primarily occurred because (1) actual overhead costs that the

business area was responsible for exceeded budget projections and (2) the

business area received lower-than-expected workload levels which

prevented it from generating enough revenue to recover its budgeted

overhead costs. These rising prices and consistent losses ultimately reduce

the purchasing power of the customers’ appropriations.

The Navy’s implementation of DBOF and its reorganization to consolidate

ordnance functions have resulted in more costs being identified and

included in the prices charged customers. This has helped to identify areas

of inefficient operations within the business area that contribute to the

price increases—principally overhead costs. However, the Navy ordnance

business area still needs to take a number of actions to ensure that

accurate and consistent information is available to effectively manage the

business operations. Specifically, we found that the business area (1) did

not accurately forecast the amount of work to be performed, (2) used a

pricing structure that did not allow individual ordnance activities to

charge prices that represented their estimated cost of doing business, and

(3) did not accurately budget and account for costs.

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Executive Summary

Principal Findings

Factors Contributing to

Price Increases

The Navy ordnance business area’s composite sales price1 increased from

$50.02 per direct labor hour (DLH) in fiscal year 1994 to $89.03 per DLH in

fiscal year 1996. We found that

• $15.25, or 39.1 percent, of the per hour increase was due to efforts to

ensure that prices more accurately reflect the full costs of the Navy

ordnance operations;

• $13.79, or 35.3 percent, of the per hour increase was attributable to DOD’s

policy that requires prices to be adjusted to recover prior year losses or

return profits (most prior year losses occurred because actual overhead

costs exceeded budgeted overhead costs);

• $5.46, or 14.0 percent, of the per hour increase stemmed from overhead

costs being allocated over a declining workload; and

• $4.51, or 11.6 percent, of the per hour increase was due to increases in

direct labor costs.

Figure 1 illustrates the percentage of price increases by category.

Figure 1: Factors Contributing to Price Increases

Full costs

Loss policy

Overhead

Labor costs

39.1%

35.3%

14.0%

11.6%

1

The composite sales price is the average amount that customers must pay for a direct labor hour.

Page 6 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary

In developing the fiscal year 1996 prices, the Navy ordnance business area

did a better job of identifying the total costs of its operations and factoring

those costs into the prices. Specifically, in determining fiscal year 1996

prices, the Navy identified and included about $87 million of estimated

costs that were not included in fiscal year 1994 prices. These were costs

incurred for military security guards, headquarters personnel, and

underutilized plant capacity. By including these additional costs in the

prices, the business area is now in a better position to identify the full

costs of its operations. Only through the identification of the full costs of

operations can management—DOD and the Navy—begin to make more

informed decisions on the appropriate action needed to reduce

infrastructure costs.

Also, in accordance with DOD’s policy, the Navy ordnance business area

increased fiscal year 1995 and 1996 prices to recover prior years’ operating

losses. Navy ordnance officials stated that DOD’s policy causes major price

fluctuations from one year to the next and drives some customers to seek

other sources for the work. To illustrate the potential magnitude and

impact of this problem, they pointed out that the estimated accumulated

loss at the end of fiscal year 1997 is expected to be about $220 million. To

recoup this loss within a year, the Navy could (1) add $49 an hour to the

fiscal year 1998 prices—a 60-percent increase over the fiscal year 1997

prices—or (2) request a direct appropriation of $220 million. DOD and the

Navy decided to increase the prices charged customers for ammunition

storage and distribution to recover these losses.

Further, because customers are ordering less work, the Navy ordnance

business area is allocating its overhead costs over a continually declining

workload base. From fiscal year 1994 through fiscal year 1996, the number

of budgeted DLHs decreased from 6.9 million to 5.7 million—a 17 percent

decrease. During this same period, the business area’s actual overhead

costs did not decrease proportionately with the decline in workload. As a

result, more overhead costs are being allocated to each direct hour. This

operating environment of declining workload and increasing prices is one

of the most critical challenges DOD currently faces. Three years ago, the

Under Secretary of Defense (Comptroller) referred to this environment as

a “vicious circle” and said it was the single largest threat to DBOF.

According to the Comptroller, DOD’s inability to reduce infrastructure costs

as fast as customer budgets are being reduced is at the center of the

dilemma. Since customers are paying higher prices for needed goods and

services and they have a finite amount of funds, their overall demand for

work is decreasing.

Page 7 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary

Factors Contributing to

Losses

The Navy ordnance business area reported losses of about $212 million for

fiscal years 1994 through 1996 and would have lost more had it not added

surcharges to its fiscal year 1995 and 1996 prices. These losses can be

attributed to several factors, but they primarily resulted from overhead

costs exceeding budget projections. In fact, the actual reported overhead

costs in fiscal years 1994 and 1995 were about $201 million higher than

budget estimates. According to GAO’s analysis and Navy ordnance officials,

these higher-than-expected overhead costs occurred because (1) DOD’s

pricing policy required the business area to absorb unanticipated cost

increases of at least $87 million, which were previously paid for by other

appropriations or major commands, and (2) the Navy ordnance business

area did not achieve savings goals that were incorporated into its budgets

by Navy and DOD budget officials.

Further, because prices charged customers are based on projected

workload, workload shortfalls adversely impacted the financial results of

the Navy ordnance business area. GAO’s analysis of budgeted and actual

DLHs for fiscal years 1994 and 1996 showed that the business area

performed about 900,000 fewer DLHs of work than it budgeted. The

lower-than-expected workload levels forced the business area to shift

many of its direct labor employees into overhead positions, and resulted in

not generating sufficient revenue to cover fixed overhead costs. The

workload shortfalls resulted in about $39.8 million in losses for the 2

years.

In addition, the Navy ordnance business area lost about $13 million related

to using Naval reserve forces to support its ordnance mission from fiscal

years 1994 through 1996. In accordance with DOD policy, the business area

bills customers for actual hours of work performed by the reserves but

reimburses the Reserve Personnel, Navy appropriation at the budgeted

amount. The budgeted hours should be based on realistic estimates of the

amount and type of work that the reserves will be able to accomplish.

However, the actual labor performed by the reserves for ordnance related

work was a reported $13 million less than the amount that the Navy

ordnance business area reimbursed the Reserve Personnel, Navy

appropriation.

Effective Management

Requires More Accurate

and Consistent

Information

While the Navy ordnance business area has improved the availability of

information needed to manage the business area by including more of the

relevant costs in the prices charged customers, it still lacks accurate and

consistent information on the amount of work to be performed and the

Page 8 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Executive Summary

cost of performing that work. This information is essential to a revolving

fund operation since (1) revenue is based on the amount of work

performed and the price charged for that work and (2) revenue should

approximate the cost of performing the work if the revolving fund is to

operate on a break-even basis.

Recommendations We are making recommendations to the Secretary of Defense and the

Secretary of the Navy for improving the Navy ordnance business area’s

operations, price-setting, and financial management practices. These

recommendations focus on (1) the Navy developing a plan to streamline

the Navy ordnance operations and reduce its infrastructure costs,

including overhead, (2) setting prices based on realistic estimates of work

to be performed, (3) setting prices that are based on costs expected to be

incurred by individual Navy ordnance activities, and (4) ensuring that

costs, especially overhead costs, are accurately allocated to the customers

benefitting from the services.

Agency Comments In its written comments on this report, DOD stated that overall the report

reasonably depicts the business activities of Navy ordnance and agreed

with three of our four recommendations. It did not agree at this time with

our recommendation on setting prices based on costs expected to be

incurred by individual activities. DOD cited the need to complete two

initiatives in order to more fully consider this recommendation. It expects

these initiatives to be completed by August 1, 1997. As part of the

congressionally mandated initiative to study working capital funds, DOD

indicated that it plans to evaluate the desirability of establishing individual

activity prices. As part of this evaluation, DOD needs to consider the

incentives that individual activities have for operating efficiently and

reducing costs.

Page 9 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Contents

Executive Summary 4

Chapter 1 

Introduction

12

Why Industrial Funds Were Established 12

DOD Established DBOF 13

Business Areas’ Budget and Price Setting Process 15

Navy Established the Naval Ordnance Center 15

Objectives, Scope, and Methodology 19

Chapter 2 

Factors Causing

Prices to Increase

22

Current Prices More Accurately Reflect Total Cost of Operations 22

Prior Year Losses Increase Sales Prices 24

Declining Workload Creates Pressure to Increase Prices 24

Higher Prices Result in Customers Shifting Work From Navy

Ordnance Business Area

25

Conclusions 27

Chapter 3 

Factors Contributing

to Navy Ordnance

Business Area Losses

28

Projected Operating Results Have Consistently Been Overly

Optimistic

28

Overhead Costs Have Been Much Higher-Than-Expected 29

Lower-Than-Expected Workload Levels Also Contributed to the

Losses

33

Naval Reserve Units Have Not Provided Expected Level of

Support

34

Conclusions 35

Recommendations 35

Agency Comments and Our Evaluation 36

Chapter 4 

Effective Management

and Oversight

Requires Accurate

and Consistent

Financial Information

37

More Reliable Workload Estimates Are Needed 37

Uniform Price Structure Is Counterproductive to Efficient

Operations

39

Budgeting and Accounting for Overhead Costs Are Neither

Accurate Nor Consistent

42

Conclusions 44

Recommendations 44

Agency Comments and Our Evaluation 45

Page 10 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Contents

Appendixes Appendix I: Comments From the Department of Defense 46

Appendix II: Major Contributors to This Report 50

Tables Table 2.1: Major Causes of the Navy Ordnance Business Area’s

Fiscal Year 1994-96 Sales Price Increase

22

Table 2.2: Budgeted Overhead Costs and Direct Labor Hours for

Fiscal Years 1994 and 1996

25

Table 3.1: Navy Ordnance Business Area’s Budgeted and Actual

Reported Operating Results for Fiscal Years 1994-96

28

Table 3.2: Navy Ordnance Business Area’s Budgeted and Actual

Reported Overhead Costs for Fiscal Years 1994-96

30

Table 3.3: Losses Caused by Workload Shortfalls 34

Table 4.1: Comparison of Individual Weapons Station’s

Composite Price Per Hour to Overall NOC Composite Price for

Fiscal Year 1996

40

Figures Figure 1: Factors Contributing to Price Increases 6

Figure 1.1: Working Capital Fund Operations 14

Figure 1.2: Naval Ordnance Center Activities 17

Figure 1.3: Navy Ordnance Workload as a Percent of Revenue 18

Figure 1.4: Navy Ordnance Workload 19

Figure 3.1: Estimated vs. Actual Results 29

Figure 3.2: Estimated vs. Actual Overhead 30

Abbreviations

DBOF Defense Business Operations Fund

DFAS Defense Finance and Accounting Service

DLH direct labor hour

DOD Department of Defense

GAO General Accounting Office

MTIS materials turned into stores

NOC Naval Ordnance Center

NWAD Naval Warfare Assessment Division

Page 11 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

When Defense established the Defense Business Operations Fund (DBOF)

in 1991, it was attempting to fundamentally alter the way DOD manages its

resources by fostering a more business-like culture within selected

defense operations. DBOF, a revolving fund financial structure, was

essentially an extension of the stock and industrial funds that have

operated within DOD for about 45 years. One of the primary goals of DBOF

was to identify the total costs of operations and to highlight the cost

implications of management decisions. The Navy ordnance business area

has operated under the industrial fund concept since 1953 and became

part of DBOF when it was established in 1991. On December 11, 1996, the

Navy ordnance business area became part of the Navy Working Capital

Fund when the Under Secretary of Defense (Comptroller) dissolved DBOF.

The Comptroller reorganized DBOF to clearly establish the military

services’ and DOD components’ responsibilities for managing the functional

and financial aspects of their respective business areas. The Navy Working

Capital Fund will continue to operate under the revolving fund concept

and charge customers the full costs of providing goods and services to

them as currently defined in DOD’s Financial Management Regulation,

Volume 11B, Reimbursable Operations, Policy and Procedures—Defense

Business Operations Fund.

Why Industrial Funds

Were Established

During the 1940s, the Hoover Commission, while studying abuses in

government operations, found that the military budget and appropriation

processes were highly inefficient. For example, the Commission found

that managers at industrial activities did not know the cost of individual

jobs and, therefore, concentrated on obtaining funds to support their

existing programs rather than improving the efficiency of their operations.

Similarly, the Commission found that, because industrial activities’

customers were not charged for the work performed, they were seldom

constrained by financial considerations.

To correct problems such as these, the Congress, in 1949, amended the

National Security Act of 1947 to authorize the establishment of industrial

funds.1

 In establishing the funds, the Congress intended to introduce the

discipline and incentives of private industry and commerce to DOD

industrial activities and their customers. Industrial funds were expected to

improve government operations by establishing a buyer-seller relationship

between fund activities and their customers. The fund activities would be

financially dependent on obtaining orders and matching costs with

reimbursements. Consequently, they would be motivated to (1) improve

1

This authorization is now found at 10 U.S.C. 2208.

Page 12 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

cost estimates and controls and (2) identify and correct inefficiency and

waste. Customers would pay for services rendered and would, therefore,

be motivated to order only necessities.

DOD Established

DBOF

In October 1991, DOD established DBOF, 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, the Defense

Industrial Plant Equipment Service, the Defense Commissary Agency, the

Defense Reutilization and Marketing Service, and the Defense Technical

Information Service into a single financial structure. The military services

and DOD components continued to be responsible for managing and

operating the business activities within this financial structure. DBOF’s

fiscal year 1996 revenue of about $81 billion made it equivalent to one of

the largest corporations in the world.

Under the recently established four working capital funds, the business

areas will continue to operate the same way they did under DBOF. DBOF’s

primary goal and that of the current working capital fund structure is to

focus the attention of all levels of management on the total costs of

carrying out certain critical DOD business operations and the management

of those costs in order to encourage support organizations, such as

maintenance facilities, to provide quality goods and services at the lowest

cost. Accomplishing this will require DOD managers to become more

conscious of operating costs and make fundamental improvements in how

DOD conducts business. Unlike a private sector enterprise which has a

profit motive, the objective of DBOF and the four working capital funds is to

operate on a break-even basis by recovering the costs incurred in

conducting the business operations. It is critical for business areas to

operate efficiently since every dollar spent on infrastructure is one less

dollar available for other defense spending priorities. The business areas

provide essential goods and services needed for maintaining military

readiness including 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.

DBOF received its initial working capital of $6.5 billion through a transfer of

resources from the nine existing industrial and stock funds in 1991. As

figure 1.1 illustrates, the business areas used these resources to finance

the initial cost of providing the goods and services that are ordered by

their customers. Customers use appropriated funds, primarily Operation

and Maintenance appropriations, to finance these orders. Thereafter, as

Page 13 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

the business areas perform work and incur costs, they bill customers on

the basis of predetermined prices—commonly referred to as standard or

stabilized prices. Payments from customers are then used to finance

subsequent operations, much as sales revenues are used in commercial

enterprises.

Figure 1.1: Working Capital Fund

Operations

Customers

Working Capital 

Fund

1. Place orders.

2. Obligate appropriations (when 

accepted by the working capital 

fund).

3. Receive requested goods and 

services.

4. Reimburse the working capital 

fund.

1. Receive customer orders, 

screen, accept.

2. Perform work (incurring costs 

for labor, material, and 

contracts).

3. Provide goods and services.

Customer 

orders

Goods 

and 

services

Appropriates funds

Billing Payments

Page 14 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

Business Areas’

Budget and Price

Setting Process

Present DOD policy requires the business areas to establish prices that

allow them to recover from their customers the expected costs, including

any prior years’ losses. The business areas are to establish prices before

the start of each fiscal year and apply these predetermined prices to most

orders and requisitions received during the year. Because sales prices are

based on expected costs and workload, (1) higher-than-expected costs or

lower-than-expected customer demand for goods and services can cause

business areas to incur losses and (2) lower-than-expected costs or

higher-than-expected customer demand for goods and services can result

in profits. Therefore, in order for a business area to operate on a

break-even basis, it is extremely important that the business area

accurately estimate the work it will perform and the costs of performing

the work.

The process that business areas use to develop their stabilized prices

begins as early as 2 years before the prices go into effect, with each

business area developing workload projections for the budget year. After a

business area estimates its workload based on customer input, it (1) uses

productivity projections to estimate how many people it will need to

accomplish the work, (2) prepares a budget that identifies the labor,

material, and other expected costs, and (3) develops prices that, when

applied to the projected workload, should allow it to recover operating

costs from its customers.

Major commands responsible for the overall management of the various

business areas review and consolidate individual business area activities’

budget estimates. The military services’ and DOD components’

headquarters and the Office of the Secretary of Defense review the

consolidated estimates before they are submitted to the Congress as part

of the annual budget. Any changes made during the DOD budget review

process are incorporated into the business areas’ prices before the start of

the fiscal year.

Navy Established the

Naval Ordnance

Center

In October 1993, the Navy reorganized the Navy ordnance business area

and established the Naval Ordnance Center (NOC) in order to address

various ordnance logistics management deficiencies that had been

identified during Desert Shield/Desert Storm operations and by various

working groups and studies. These deficiencies included (1) unresponsive

support to the fleets, (2) a fragmented inventory management function

that made it difficult for the fleets to identify the people who could resolve

their ordnance problems, and (3) an information system that did not give

Page 15 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

managers adequate visibility over ordnance. The creation of NOC was

expected to alleviate these problems and to allow the Navy to use a

streamlined and integrated ordnance team to “provide the right ordnance,

in the right quantity and condition, to the right customer, at the right place,

at the right time, and at the right cost.”

The establishment of NOC was also expected to save about $173 million

annually—primarily by consolidating ordnance support functions

previously performed by the Naval Air Systems Command, Naval Sea

Systems Command, Naval Supply Systems Command, and five fairly

autonomous Naval weapons stations. The $173 million in savings would be

shared by these components. Specifically, the Navy expected to save most

of the money by transferring ordnance-related headquarters functions

from the three systems commands to NOC Headquarters, transferring most

of the weapons stations’ administrative functions to two new divisions

(Atlantic and Pacific Divisions), and consolidating in-service engineering

support for ordnance items. Currently, the Navy ordnance business area

consists of NOC Headquarters and the Atlantic and Pacific Divisions

described above; five Naval weapons stations; two weapons station

detachments; the Naval Warfare Assessment Division; and the Inventory

Management and Systems Division. NOC’s activities and their locations are

shown in figure 1.2.

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Chapter 1 

Introduction

Figure 1.2: Naval Ordnance Center Activities

Headquarters

Earle 

Yorktown and Atlantic Division

Charleston

Seal Beach and Pacific Division

Concord

Fallbrook 

1

2

1. Navy Warfare Assessment 

Division

2. Inventory Management 

System Division

Activities

Port Hadlock

Although this business area was called the Navy ordnance depot

maintenance business area until December 1996, only 4 percent of the

work preformed by the business area involves depot maintenance. DOD

defines depot maintenance as material maintenance requiring major

overhaul or a complete rebuilding of parts, assemblies, subassemblies, and

end items. However, as shown in figure 1.3, one of the business area’s core

requirements and largest workloads—ammunition storage and

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Chapter 1 

Introduction

distribution—involves the receipt, segregation, storage and issue of

ammunition, as well as all services related to ammunition loading and

unloading of naval ships and commercial vessels.2

 Other workloads

include (1) ordnance engineering services, such as gauging the war

fighting capacity of ships and aircraft—from unit to battle group level—by

assessing the suitability of design and performance of weapons,3

(2) general support, such as providing security, real property maintenance,

and other base operations support services to the weapons stations’ tenant

activities, and (3) performing intermediate level maintenance, such as

replacing defective ordnance components. Recognizing that this business

area did not perform much depot maintenance work, DOD changed the

name of the business area to Navy ordnance in December 1996.

Figure 1.3: Navy Ordnance Workload as a Percent of Revenue

4.0%

9.0%

23.0%

40.0%

17.0%

7.0% Exempt from stabilized rate

Intermediate maintenance

Ammunition storage and distribution

Engineering

General support

Depot maintenance

Over the last several years, the amount of work that this business area has

received from its customers has steadily declined due to the downsizing

and realignment actions that have been occurring throughout the DOD

military force structure. As shown in figure 1.4, the amount of work

2

See Defense Ammunition: Significant Problems Left Unattended Will Get Worse (GAO/NSIAD-96-129,

June 21, 1996), for problems related to the storage of ammunition.

3

This mission is accomplished by the Naval Warfare Assessment Division, which is located in Corona,

California.

Page 18 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

performed by NOC declined from a reported 9.7 million DLHs in fiscal year

19924

 to 5.1 million DLHs in fiscal year 1996—a 47 percent decrease. At the

same time, NOC has reduced its personnel from 8,904 to 5,363—a

40 percent reduction. While the number of personnel has decreased, it has

not been proportional to the decrease in workload because of the

difficulty involved in quickly releasing employees when the workload

declines.

Figure 1.4: Navy Ordnance Workload (in Millions of Direct Labor Hours)

1992 1993 1994 1995 1996

0

2

4

6

8

10

12

Fiscal Year

Source: Navy Ordnance Business Area.

Objectives, Scope,

and Methodology

The objectives of our audit were to determine (1) the causes of the Navy

ordnance business area price increases that took place from fiscal year

1994 through fiscal year 1996, (2) why the Navy ordnance business area

4

The amount of work performed in fiscal year 1992 was extraordinarily high due to Desert

Shield/Desert Storm.

Page 19 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 1 

Introduction

incurred about $212 million in reported losses during that 3-year period,

and (3) whether management has accurate and consistent financial

management information for effectively managing the Navy ordnance

business area.

To determine what factors caused the prices to increase between fiscal

years 1994 and 1996, we obtained and analyzed NOC’s workload budgets for

fiscal years 1994 through 1996 and compared them with actual workload

results to identify variances from budgeted amounts. For identified

differences, we met with responsible accounting and program officials to

ascertain (1) why there were differences and (2) how the differences

affected prices. We also analyzed the budgets for fiscal years 1994 through

1996 to determine the cost factors used in developing the prices. We met

with responsible Navy comptroller and program officials at NOC

Headquarters, the Atlantic and Pacific Divisions, and selected weapon

stations to identify and discuss the rationale for the various factors used

(or not used) to develop the Naval ordnance business area’s prices it

charged customers.

To determine what factors caused the Navy ordnance business area to

incur about $212 million in reported losses from fiscal year 1994 through

fiscal year 1996, we analyzed budget reports and related data for fiscal

years 1994 through 1996 and compared budgeted direct and overhead

costs to actual direct and overhead costs to identify variances from the

budgeted amounts. For identified differences, we met with responsible

accounting and program officials to ascertain (1) why there were

differences and (2) how the differences resulted in losses incurred by the

Navy ordnance business area.

To determine if management had accurate and consistent information for

effectively managing the business area, we reviewed (1) workload

forecasts to determine if they were accurate, (2) the NOC’s uniform price

concept and the impact that this practice has on the individual weapons

station net operating results, and (3) the allocation of overhead costs to

specific workloads to determine if they were accurate. We also reviewed

DOD Inspector General and Naval Audit Service Chief Financial Officer

reports on the business area’s financial statements to identify any

problems they may have found with the business area’s financial

information. We did not independently verify the financial information

provided by the Navy ordnance business area.

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Introduction

We performed our work at the Office of the DOD Comptroller, Washington,

D.C.; the Offices of the Assistant Secretary of Navy (Financial

Management and Comptroller), Naval Sea Systems Command, Naval Air

Systems Command, and Headquarters, Defense Finance and Accounting

Service, all located in Arlington, Virginia; the Naval Ordnance Center

Headquarters, Indian Head, Maryland; the Naval Ordnance Center Atlantic

Division, Yorktown, Virginia; the Naval Ordnance Center Pacific Division,

Seal Beach, California; the Naval Weapons Station, Yorktown, Virginia; the

Naval Weapons Station, Charleston, South Carolina; the Naval Weapons

Station, Earle, New Jersey; the Naval Weapons Station, Seal Beach,

California; the Naval Weapons Station, Concord, California; and the Naval

Warfare Assessment Division, Corona, California. Our work was

performed from June 1996 through February 1997 in accordance with

generally accepted government auditing standards.

DOD provided written comments on a draft of this report. We incorporated

DOD’s comments where appropriate. These comments are discussed in

chapters 3 and 4 and are reprinted in appendix I.

Page 21 GAO/AIMD/NSIAD-97-74 Navy Ordnance
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Factors Causing Prices to Increase

The Navy ordnance business area’s composite sales price increased from

$50.02 per DLH in fiscal year 1994 to $89.03 per DLH in fiscal year 1996, or

about 78 percent.1

 As this chapter discusses, a large part of this

increase—39.1 percent—was due to efforts to ensure that the business

area’s prices fully reflect the cost of providing goods and services to

customers—a primary goal of working capital funds. About 50 percent of

the price increase, however, was attributable to two other factors: (1) the

Navy’s compliance with a Defense requirement to reflect prior-year profits

and losses in prices and (2) the spreading of overhead costs to fewer DLHs

due to a rapidly declining workload. Each of the causes for the price

increase are shown in table 2.1. Setting prices based on full costs allows

business area managers to make more informed policy decisions;

however, they have also caused some ordnance customers to find other

sources to perform their work at lower prices.

Table 2.1: Major Causes of the Navy

Ordnance Business Area’s Fiscal Year

1994-96 Sales Price Increase Cause of increase

Impact on

rate

Percent of

increase

Additional cost components captured

that were previously financed by other 

appropriations or major commands

$15.25 39.1

Prior year losses 13.79 35.3

Declining workload 5.46 14.0

Direct labor costs 4.51 11.6

Total $39.01 100.0

Current Prices More

Accurately Reflect

Total Cost of

Operations

The Navy ordnance business area has been working to implement DBOF

and is capturing more of the total cost of its operations and reflecting

those costs in the prices charged customers. As shown in table 2.1, our

analysis indicates that $15.25, or about 39.1 percent, of the Navy ordnance

business area’s price increase from fiscal year 1994 to fiscal year 1996 was

attributable to Navy and DOD efforts to ensure that all relevant costs were

identified and included in the sales prices. Until the establishment of DBOF

in October 1991, significant overhead costs were (1) contained in different

organization structures and paid by different appropriations or major

commands and (2) excluded from the prices charged customers. DBOF’s

total cost concept, along with the Navy’s reorganization, consolidated

Navy ordnance costs by shifting the costs from the different organization

structures to the Navy ordnance business area. These previously excluded

costs relate to (1) overhead and (2) underutilized plant capacity.

1

If the fiscal year 1994 sales price is converted to fiscal year 1996 dollars, it would be $52.47 per direct

labor hour. This would reduce the increase in price to 70 percent.

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Factors Causing Prices to Increase

Fiscal Year 1996 Prices

Include New Costs

About $7.93 of the $15.25 price increase can be attributed to overhead

costs that were included in the 1996 prices, but not the 1994 prices. These

costs include

• $12.5 million for military security guards, which were previously financed

by the Military Personnel, Navy appropriation ($2.19 per DLH);

• $11.9 million for Navy ordnance headquarters functions, which were

previously financed by the Operation and Maintenance, Navy

appropriation ($2.09 per DLH);

• $10.8 million for the Inventory Management Support Division, which was

previously financed by DBOF’s Navy supply management business area

($1.89 per DLH); and

• $10 million for functions related to explosive safety, nuclear security,

ordnance handling, and sensitive ordnance security, which were

previously financed by the Operation and Maintenance, Navy

appropriation ($1.76 per DLH).

By including these additional costs in the prices, business area managers

can more easily focus on and manage the relevant costs. In addition, the

more accurate identification of costs should enable those responsible for

providing oversight to make more informed policy decisions.

Cost of Underutilized Plant

Capacity Now Included in

Sales Prices

Like many of the business areas, the Navy ordnance business area must

always maintain the capability to meet rapid escalation of demand for its

services in times of war or other military emergencies. A 1994 DOD policy

change affected the way costs associated with maintaining this

mobilization capability are financed and is responsible for $7.32 of the

$15.25 price increase. According to the DOD Financial Management

Regulation, Volume 11B, mobilization capability costs include costs to

maintain a surge capability, to procure and maintain approved war reserve

material levels, and/or maintain other assets, functions, or capabilities

required to meet an operational contingency.

Under the old policy, if underutilized facilities, equipment, or

infrastructure were needed in order to meet mobilization surge

requirements, then the costs related to maintaining the underutilized

assets were to be determined, budgeted, and financed by a direct

appropriation—rather than as overhead costs that are incorporated into

customers’ sales prices. While the Navy ordnance business area used the

facilities and equipment, that use was less than the full capacity of an

operating facility.

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Factors Causing Prices to Increase

However, under the new policy, the cost of maintaining these assets is not

funded as a mobilization requirement unless the assets are expected to be

unused for 6 consecutive months. This policy change also addressed

concerns that the Senate Appropriations Committee raised in its reports

on DOD’s fiscal years 1994 and 1995 appropriations.2

 Specifically, the

committee reports questioned the need for funding underutilized plant

capacity and noted that using direct appropriations to subsidize Navy

industrial maintenance facilities was contrary to the DBOF concept of

capturing the full cost of operations.

Prior Year Losses

Increase Sales Prices

As noted previously, DOD policy requires business areas to adjust their

prices in order to recoup accumulated losses from or return accumulated

profits to their customers. In accordance with this policy, the business

area decreased its fiscal year 1994 sales prices to return a profit of

$38.1 million that was projected for the end of fiscal year 1993. Similarly,

when it established the business area’s fiscal year 1996 prices, the Navy

increased its prices to recoup a loss of about $47 million that was

projected for the end of fiscal year 1995. Following this policy resulted in a

net increase of $13.79 per hour, or about 35 percent, of the price increase

from fiscal year 1994 to fiscal year 1996.

To illustrate the potential magnitude and impact of including prior year

losses in prices, Navy ordnance comptroller officials pointed out that their

business area’s accumulated loss at the end of fiscal year 1997 is expected

to be about $220 million. To recoup this loss, the Navy could either (1) add

about $49 to the fiscal year 1998 prices—a 60 percent increase over the

fiscal year 1997 prices—an increase high enough to drive more customers

away or (2) seek a $220 million direct appropriation. DOD and the Navy

decided to increase the prices charged customers for ammunition storage

and distribution to recover these losses.

Declining Workload

Creates Pressure to

Increase Prices

Since the military forces have been downsizing over the last several years,

the demand for Navy ordnance work has declined. However, the business

area’s overhead costs have not decreased proportionately to the decline in

workload. This has caused the business area to allocate its overhead costs

over a steadily declining workload base and, in turn, to allocate more

overhead costs to each DLH of work that is accomplished. Our analysis

indicates that workload reductions accounted for $5.46, or about

14 percent, of the price increase from fiscal year 1994 through fiscal year

2

Senate Reports 103-153 and 103-321.

Page 24 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 2 

Factors Causing Prices to Increase

1996. The magnitude of these workload reductions affects the amount of

budgeted overhead cost per DLH as illustrated in table 2.2.

Table 2.2: Budgeted Overhead Costs

and Direct Labor Hours for Fiscal

Years 1994 and 1996

Fiscal year

Budgeted

overhead costs

(millions)

Budgeted direct

labor hours

(millions)

Budgeted

overhead cost

per DLHa

1994 $206 6.9 $29.72

1996 $200b 5.7 $35.18

aPrice per hour may not be precise due to rounding.

bThe total budgeted overhead cost was $287 million for fiscal year 1996. In order to compare the

fiscal year 1994 and 1996 budgeted overhead figures, we adjusted the fiscal year 1996 figure by

$87 million because (1) new overhead costs were added and (2) of a change in the financing of

underutilized plant capacity.

Higher Prices Result

in Customers Shifting

Work From Navy

Ordnance Business

Area

Due to higher prices, some customers are shifting work from the Navy

ordnance business area to other sources. Customers are shifting work

from the business area to nonworking capital fund activities that are not

required to charge the full cost of doing business, such as not charging the

cost of military personnel. Since the Navy ordnance business area is

required to charge customers the full cost and nonworking capital fund

activities are not required to do so, this situation creates a competitive

disadvantage for the Navy ordnance business area. Further, some

customers shifted work to other working capital fund activities that are

capturing full costs but offering lower prices. Some examples follow.

• In one instance related to the calibration maintenance of the Mark 48

torpedo support equipment, we found that the work previously done by

the Yorktown Weapons Station was now being done at an activity located

at the Norfolk Naval base for about one third of the price. According to the

commander of the Mark 48 torpedo maintenance facility, which was also

located on the Yorktown Weapons Station, he paid the Norfolk Naval base

about $40,000 during fiscal year 1996 for over 1,000 hours of work. The

commander told us that if he had given the work to Yorktown, he would

have been charged about $110,000 or about three times as much. The large

difference in prices occurred because the Norfolk activity was not a

working capital fund business activity and thus was not required to charge

labor and overhead costs which Yorktown, being a working capital fund

activity, had to charge. The Norfolk activity only charged the costs of

pieces and parts needed to perform the calibration work on the torpedo

support equipment.

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Factors Causing Prices to Increase

• In another case, the Concord Naval Weapons Station lost about 103,000

DLHs of work related to the Air Force’s prepositioned ships program that

had been included in its fiscal year 1997 budget. Concord has performed

this work, which involves loading and unloading ammunition ships, for the

last several years. However, the Army’s military ocean terminal at Sunny

Point, North Carolina—which performed much of the work prior to

1993—won a formal competition for the work in fiscal year 1997.

According to Air Force program managers, Concord was as qualified to do

the work as Sunny Point. However, these managers said that a major

factor in deciding to award the work to Sunny Point was that its

$9.5 million bid was about $3 million less than Concord’s bid. In discussing

this matter with Concord officials, they indicated that the elimination of

this workload will result in a loss of about $7 million—primarily because it

will (1) prevent them from recouping about $6.5 million in fixed overhead

costs and prior year losses, and (2) force them to place some of their

workers into overhead positions for part of the year.

• We also found that the Naval Ships Parts Control Center, which was

previously a Yorktown customer, transferred its workload related to the

inspection and repair of various steam valves and other items of materials

turned into stores (MTIS) by Navy submarines. According to the Acting

Director of Ship Parts Control Center’s MTIS program, the work was

transferred to the Defense Distribution Depot Norfolk, also a working

capital fund activity, primarily because Norfolk charged substantially less

than Yorktown. For example, at the time of transfer on October 1, 1995,

Yorktown was charging $180 to inspect and repair each lot of MTIS. This

was about 200 percent more than the $61 per lot charged by the Norfolk

Depot. The Director also told us that primary factors contributing to

Yorktown’s higher costs were the large amounts of overhead included in

the prices and Yorktown’s use of inspectors to perform the work as

opposed to lower paid depot warehousemen at the Norfolk Depot.

The operating environment of declining workloads and increasing prices is

common among many business areas and is one of the most critical

challenges DOD currently faces. In an April 1994 testimony, the Under

Secretary of Defense (Comptroller) referred to this environment as a

“vicious circle” and indicated that DOD’s inability to eliminate

infrastructure costs as fast as customer budgets are being reduced is at the

center of the dilemma. Specifically, he indicated that (1) higher prices are

causing business area customers to reduce their demand for goods and

services, (2) business areas are generally unable to reduce their costs

quickly enough to respond to the reduced demand, (3) as a result, the

business areas are incurring losses that, under current DOD policy, must be

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Factors Causing Prices to Increase

recouped through price increases, and (4) the price increases start the

whole “vicious circle” over again. As shown above, the Comptroller’s

statement is as valid today as it was 3 years ago and the Navy ordnance

business area will continue to experience this “vicious circle” until it

reduces its infrastructure costs.

Conclusions The Navy’s implementation of DBOF along with the reorganization to

consolidate ordnance functions has helped ensure that the Navy ordnance

business area’s prices reflect the total cost of doing business—a primary

objective of DBOF and the recently established working capital funds.

Setting prices based on the full costs of providing goods and services has

increased prices which, in turn, has helped to (1) identify key areas

contributing to inefficient operations within the business area,

(2) highlight the cost implications of management decisions, and

(3) provide managers with information for use in improving their

operations. On the other hand, the increases have also caused customers

to seek alternatives to the Navy ordnance business area. Improving the

efficiency of Navy ordnance operations will help alleviate his problem.

This concept is discussed more fully in the next chapter.

Page 27 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 3 

Factors Contributing to Navy Ordnance

Business Area Losses

The Navy ordnance business area reported it lost about $212 million

during fiscal years 1994 through 1996, and would have lost more if it had

not been allowed to add surcharges to its fiscal year 1995 and 1996 prices

in order to recoup prior year losses. Although many factors contributed to

these losses, our analysis indicates that they occurred primarily because

the business area (1) had higher-than-expected overhead costs, (2) did not

receive as much work as expected, and (3) had to pay for work that

reserve component units were expected to perform, but did not. In

determining the reasons for the losses, we compared budgeted

information to actual information for fiscal years 1994 through 1996. Some

of the reasons for the losses, such as unanticipated overhead costs related

to headquarters activities, also contributed to the price increases that were

discussed in chapter 2.

Projected Operating

Results Have

Consistently Been

Overly Optimistic

The annual DBOF budgets that have been submitted to the Congress have

consistently contained overly optimistic estimates for the Navy ordnance

business area’s operating results. For example, due to the DOD policy that

requires activities to use surcharges to recoup prior year losses from their

customers, the business area was expected to earn a profit of about

$47.7 million during fiscal year 1996; however, instead of making a profit,

the business area reported it actually lost about $36.7 million during the

year. Thus, these surcharges allowed the business area to reduce its losses

and caused its performance to appear better than it actually was.

Altogether, the Navy ordnance business area was expected to earn a profit

of $98.6 million during fiscal years 1994 through 1996. However, as shown

in table 3.1 and figure 3.1, because the business area’s performance was

consistently worse than expected, it incurred a net reported loss of

$211.8 million during the period.

Table 3.1: Navy Ordnance Business

Area’s Budgeted (Estimated) and

Actual Reported Operating Results for

Fiscal Years 1994-96

1994 1995 1996 Total

Dollars in millions

Budget Actual Budget Actual Budget Actual Budget Actual

($38.1) ($165.5) $89.0 ($9.6) $47.7 ($36.7) $98.6 ($211.8)

Page 28 GAO/AIMD/NSIAD-97-74 Navy Ordnance
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Factors Contributing to Navy Ordnance

Business Area Losses

Figure 3.1: Estimated (Budgeted) vs. Actual Results

FY 1994 FY 1995 FY 1996 Total

-250

-200

-150

-100

-50

0

50

100

150

Estimated

Actual

Source: Navy Ordnance Business Area.

Overhead Costs Have

Been Much

Higher-Than-Expected

The primary cause of the business area’s losses is that overhead costs have

been much higher than expected. Specifically, as shown in table 3.2 and

figure 3.2, actual reported overhead costs for fiscal years 1994 through

1996 were about $197.5 million,1

 or about 29 percent, higher than budget

estimates. Because the (1) budgets are prepared 18 to 20 months before

the beginning of the fiscal year and (2) Navy ordnance business area

reorganized in October 1993, the business area could not accurately

estimate overhead costs for fiscal years 1994 and 1995, as we discussed in

chapter 2. For fiscal year 1996, the business area was better able to

1

About $63 million of this difference is due to the fact that the Navy ordnance business area did not

receive the underutilized plant capacity funding it had budgeted for in fiscal year 1994.

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Factors Contributing to Navy Ordnance

Business Area Losses

estimate overhead costs since it had been in operation under its new

organizational structure for about 1 year.

Table 3.2: Navy Ordnance Business

Area’s Budgeted and Actual Reported

Overhead Costs for Fiscal Years

1994-96

1994 1995 1996 Total

Dollars in millions

Budget Actual Budget Actual Budget Actual Budget Actual

$205.5 $325.5 $191.2 $272.2 $287.4 $283.9 $684.1 $881.6

Figure 3.2: Estimated (Budgeted) vs. Actual Overhead

FY 1994 FY 1995 FY 1996 Total

0

200

400

600

800

1,000

Estimated

Actual

Source: Navy Ordnance Business Area.

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Factors Contributing to Navy Ordnance

Business Area Losses

According to Navy ordnance officials and our analysis, these

higher-than-expected overhead costs were primarily due to three factors:

(1) it incurred new and unanticipated costs that were previously financed

with other appropriations or by the Navy’s major commands, (2) the

weapons stations did not achieve productivity and cost reduction goals

that were incorporated into their budgets by Navy and DOD budget

officials, and (3) it is difficult for managers to reduce the size of their

workforce quickly enough to respond to declining workloads, especially

when unanticipated workload shortfalls occur. When the business area is

confronted with higher-than-expected overhead costs, it is precluded by

DOD’s price stabilization policy from passing on unanticipated cost

increases—including overhead costs—to customers during the fiscal year.

Business Area Absorbed

Unanticipated Costs

DOD policy requires business areas to establish sales prices that allow them

to recover their expected costs from their customers. It also requires them

to establish their prices before the start of each fiscal year and to apply

these predetermined or “stabilized” prices to all orders received during the

year—regardless of when the work is actually accomplished or what costs

are actually incurred. Because sales prices are based on expected rather

than actual costs, higher-than-expected costs can cause a business area to

incur losses and lower-than-expected costs can result in profits.

DOD established this “price stabilization” policy in 1975 to protect revolving

fund customers from unforeseen inflationary increases and other cost

uncertainties. The intent of the policy is to ensure that customers will not

have to reduce their programs because of higher-than-expected prices.

This policy should also allow customers to provide more reliable workload

estimates to business areas which, in turn, should allow the activities to

better plan for the efficient use of their resources. We agree with this

policy since the policy protects appropriated fund customers from

unforeseen changes. This enables the customers to buy goods and services

from the four working capital funds as shown in the budgets presented to

the Congress. For example, if a customer needed 100 engines overhauled,

a change in the price may result in the customer only having enough funds

to have 75 engines overhauled, thereby impacting the customers’ readiness

capability.

When a business area is confronted with higher-than-expected costs, it is

precluded by DOD’s price stabilization policy from increasing prices

charged customers during the fiscal year. For example, the business area’s

fiscal year 1994 sales prices were based on the assumption that the cost of

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Factors Contributing to Navy Ordnance

Business Area Losses

maintaining underutilized plant capacity (to meet wartime contingency

requirements) would be financed through a transfer of $63.2 million from

the Navy Operation and Maintenance appropriation; however, as

discussed previously, this method of financing underutilized capacity was

changed after the stabilized prices had been established and, as a result,

the business area incurred the costs but could not pass them on to its

customers.

Similarly, many costs related to the establishment of NOC were not

included in the business area’s fiscal year 1994 prices and, as a result, the

business area incurred the costs but could not pass them on to its

customers in that year. For example, Navy ordnance officials estimate that

the business area lost about $16.9 million since the fiscal year 1994 prices

were developed before the reorganization of the business area and thus

did not include the cost of headquarters functions that were transferred

from the Navy’s three systems commands and inventory management

functions that were transferred from the Navy’s supply management

business area.

Anticipated Budget

Savings Did Not

Materialize

Another major contributor to the business area’s higher-than-expected

overhead costs was the failure to achieve cost reductions and productivity

improvement goals that were incorporated into budget estimates. For

example, Navy ordnance officials estimate that the business area lost

about $13 million in fiscal year 1994 as a result of Defense Management

Report Decisions that reduced their cost estimates based on the invalid

assumption that (1) the establishment of DBOF would result in a 1-percent

reduction in costs and (2) additional savings could be achieved by

consolidating automated data processing functions. Because these cost

reductions did not materialize, the business area incurred the costs which

were not fully recouped by the prices it was charging.

In another case, a DOD budget analyst questioned the Navy’s decision to

reduce cost estimates based on the assumption that general and

administrative costs could be reduced by 3 percent a year during the fiscal

year 1996 budget review process. Specifically, the analyst noted that (1) no

additional guidance or policy direction, plan, program, or detailed action

was provided to show how the savings would be achieved, (2) NOC and the

weapons stations had not achieved prior productivity goals that had also

focused on overhead costs, and (3) the new savings goal that was not

supported by any identifiable plan appeared to be a repeat of the same

error. The budget analyst also pointed out that overly optimistic savings

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Factors Contributing to Navy Ordnance

Business Area Losses

assumptions such as these had contributed to the losses that the business

area had incurred over the last several years.

Properly Matching

Workload and Workforce

Size Is Difficult

A final major cause of the Navy ordnance business area’s

higher-than-expected overhead costs is that it has not been able to quickly

and effectively reduce its workforce to meet the declining demand for

goods and services. For example, Navy ordnance officials stated that they

incurred losses during fiscal year 1995 because they had to retain

unneeded personnel until the workforce could be reduced through either

early retirement and separation incentive pay or a reduction-in-force.

These officials pointed out that the problem of not being able to quickly

reduce workforce levels to meet demand has been exacerbated by their

limited ability to control which personnel and skills are retained.

Navy ordnance officials can limit the adverse impact of this problem if

they have sufficient time to plan for changes or can use temporary

workers. For example, if they could forecast major workload reductions 2

years in advance, they could restrict hiring during the intervening 2 years

and, if appropriate, initiate other actions such as offering separation

incentive pay or implementing a reduction-in-force. Another possible

solution is to use temporary and intermittent2

 workers for all but a core or

base-level workload. For example, as of September 30, 1996, 225, or about

37 percent, of the Concord Navy Weapons Station’s employees were either

temporary or intermittent workers. However, the use of temporary and

intermittent workers is much less common at the rest of the business

area’s activities and, as of September 30, 1996, only 278, or about

7 percent, of the business area’s remaining employees were either

temporary or intermittent workers.

Lower-ThanExpected Workload

Levels Also

Contributed to the

Losses

The Navy ordnance business area lost about $39.8 million during fiscal

years 1994 through 1996 because lower-than-expected workload levels

prevented it from generating enough revenue to recover its overhead

costs. According to Navy ordnance officials, overhead costs for such

things as the salaries of administrative personnel are generally fixed costs

over the short term and are, therefore, usually incurred regardless of the

amount of work received during the year. As a result, as shown in table

3.3, a shortfall of 304,617 DLHs of work in fiscal year 1994 resulted in a loss

2

Temporary workers are hired for a specified period of time, while intermittent workers are permanent

employees who are used only when needed.

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Factors Contributing to Navy Ordnance

Business Area Losses

of about $9.1 million, and a shortfall of 609,793 hours in fiscal year 1996

resulted in a loss of about $30.8 million.

Table 3.3: Losses Caused by Workload

Shortfalls Workload (DLHs) Fiscal

year Budget Actual Shortfall

Budget

overhead

costs per DLH

Loss

(millions)

1994 6,915,205 6,610,588 304,617 $29.72 $ 9.1

1996 5,697,500 5,087,707 609,793 $50.44 30.8

Total 12,612,705 11,698,295 914,410 $39.8a

aTotal is not precise due to rounding.

During the fiscal year 1996 budget review process, which occurred in late

1994, both Navy and DOD budget analysts expressed concern about

apparent differences between the Navy ordnance business area’s

workload estimates and those of its customers. Our analysis showed that

these problems continued when the business area’s fiscal year 1997 budget

was developed. For example, Navy ordnance officials used a workload

estimate of 6.3 million DLHs to develop their fiscal year 1997 sales prices,

however, after the prices were set, the officials reduced the estimate by

about 1.6 million hours, or about 25 percent. As a result, they now expect

to incur about $66 million in losses in fiscal year 1997. Chapter 4 discusses

this problem in more detail.

Naval Reserve Units

Have Not Provided

Expected Level of

Support

The Navy ordnance business area lost about $13 million during fiscal years

1994 through 1996 because it had to pay for work that Naval Reserve units

were expected to accomplish but did not. This work was to be

accomplished as part of a cost savings initiative that was expected to

eventually save about $18 million a year. The basic concept was for

reservists to accomplish work at weapons stations during their weekend

drills and annual training periods and to thereby eliminate the need for

about 450 civilians workers. In return for this support, the business area

was required to reimburse the Reserve Personnel, Navy appropriation.

The losses occurred because the business area was required by Navy

policy to reimburse the Reserve Personnel, Navy appropriation based on

expected levels of support that subsequently did not materialize and were

determined to be unattainable. For example, Navy ordnance officials

estimate that they lost about $6 million during fiscal year 1994 because

they paid the Reserve Personnel, Navy appropriation $8 million for the

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Factors Contributing to Navy Ordnance

Business Area Losses

equivalent of 222 years of support but actually received only 58 years of

support.

A December 1996 Naval Audit Service report3

 concluded that “The

reservists capability to provide contributory support was so limited that

no significant savings were achievable and reimbursement for

contributory support was not supportable. Our review showed that about

50 percent of the reservists lacked military rating skills for ordnance

handling and 51 percent of the reservists had less than 1-year of

experience in their reserve billets.” The Chief of Naval Operations has

subsequently agreed to implement a Naval Audit Service recommendation

to discontinue the reimbursement requirement, effective October 1, 1997.

Conclusions The Navy ordnance business area has not been able to meet its financial

goal of operating on a break-even basis. For fiscal years 1994 through

1996, the business area reported losses of about $212 million primarily

because (1) actual overhead costs exceeded budgeted overhead costs and

(2) it did not receive as much work as expected. These problems continue

to exist and Navy ordnance comptroller officials believe that the business

area will incur losses of about $66 million in fiscal year 1997. The Navy

ordnance business area will likely continue to increase its prices and/or

lose millions of dollars—as it has in the past—until it effectively plans for

and reduces its infrastructure costs, especially overhead costs, so that

these costs are commensurate with reduced customer demand for

ordnance services.

Recommendations To ensure that the Navy ordnance business area operates on a break-even

basis, we recommend that the Secretary of Defense direct the Secretary of

the Navy to develop a plan to streamline the Navy ordnance operations

and reduce its infrastructure costs, especially overhead costs. This plan

should (1) concentrate on eliminating unnecessary infrastructure,

including overhead, (2) identify specific actions that need to be

accomplished, (3) include realistic assumptions about the savings that can

be achieved, (4) establish milestones, and (5) clearly delineate

responsibilities for performing the tasks in the plan.

3

“Use of and Reimbursement for Reserve Military Manpower at Naval Weapons Stations” (007-97).

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Factors Contributing to Navy Ordnance

Business Area Losses

Agency Comments

and Our Evaluation

DOD agrees with our recommendation to develop a plan to streamline Navy

ordnance operations and reduce its infrastructure costs, especially

overhead costs.

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Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

Having reliable and readily accessible financial management information

is essential to the effective and efficient operation of any business entity

since it enables managers to account for past activities, manage current

operations, and assess progress toward planned objectives. For a

revolving fund operation, such as the Navy ordnance business area, this

would mean that managers need to have accurate and consistent

information on work to be performed and the price charged customers

that should reflect the cost of performing the work. Such information

would help managers ensure that (1) revenue is based on the amount of

work performed and the price charged for that work and (2) revenue

approximates the cost of performing the work, in accordance with the

goal of operating business areas on a break-even basis. This information

could also be used to identify operational inefficiencies so that managers

can take appropriate actions.

As noted earlier in this report, for fiscal years 1994 through 1996, the Navy

ordnance business area has reported losses of about $212 million and

estimates that it will lose about $66 million in fiscal year 1997. We found

that management’s ability to stem these losses is being hindered by the

absence of the essential information we cited above. Specifically, the Navy

ordnance business area (1) did not accurately forecast the amount of work

to be performed, (2) used a pricing structure that did not allow individual

ordnance activities to charge customers prices that represented their

estimated cost of doing business, and (3) did not accurately budget and

account for costs, especially overhead costs, related to performing work.

More Reliable

Workload Estimates

Are Needed

Over the past several years, the difference between the budgeted DLHs and

the actual direct hours worked has varied widely. Because prices charged

Navy ordnance customers are based, in part, on the projected workload to

be performed, fluctuations in the amount of direct work and the type of

work performed have resulted in the losses. As discussed in chapter 3, the

loss of workload has caused substantial losses because it prevented the

business area from recovering its fixed overhead costs. In an attempt to

develop more reliable workload estimates, in 1995, the Navy ordnance

business area began contacting customers to determine if the customers

had identified any changes in the amount of work they expected to give to

the Navy ordnance business area. However, Navy ordnance officials

estimate that the workload forecast used to develop the fiscal year 1997

prices is overstated by 1.6 million DLHs, or 25 percent of the original

forecast. Until the Navy ordnance business area is able to more accurately

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Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

forecast workload and properly size its workforce to the amount of work

it receives, the business area will continue to incur losses.

Workload Validations

Identified Many Problems

The Navy ordnance business area began validating the workload estimates

in 1995 because work was not showing up as the customers and the Navy

ordnance business area had planned. In 1995, the Navy ordnance business

area validated the fiscal years 1996, 1997, and 1998 workload estimates for

its major customers and, in 1996, they validated the fiscal years 1997, 1998,

and 1999 estimates. The 1995 and 1996 validations determined that the

Navy ordnance business area would not receive about 12 percent and

15 percent of the fiscal years 1996 and 1997 forecasted workload,

respectively.

Navy ordnance officials informed us that the major reason causing actual

workload to vary from budgeted workload is that they begin formulating

workload estimates 18 to 20 months before the start of the fiscal year. The

Navy Comptroller’s office and the Office of the Secretary of Defense adjust

the workload estimates with the final adjustments occurring about 9

months before the beginning of the fiscal year. In preparing the workload

estimates so far in advance, forecasts of the amount of work to be

received from customers are based on assumptions, and thus are not

always accurate. For example, (1) the Navy ordnance business area

finalizes its workload estimates before the customers’ budgets are

finalized, (2) the customers’ original estimates sometimes represent the

total unfunded workload requirements, or unconstrained requirements,

which are generally reduced in the budget process because of funding

limitations, (3) there is no formal commitment between the customer and

the Naval ordnance business area on the amount of work to be performed

when the budget estimates are developed, and (4) the customer is not

penalized if less work is ordered than originally planned. These workload

estimates are used in developing the prices that the business area will

charge its customers.

Based on the more recent workload shortfalls and the Navy ordnance

workload validations, the Navy ordnance business area has reduced the

workforce needed to accomplish work. For example, (1) during fiscal year

1995, the Navy ordnance business area reduced its workforce by 657

through voluntary separations and two reductions-in-force and (2) in fiscal

year 1996, the business area did not hire people even though it was

authorized to do so. However, the Navy ordnance business area has

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Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

continued to be optimistic in estimating its workload. For example, about

600,000 DLHs of expected work did not materialize in fiscal year 1996.

Workload Forecasting

Continues to Be a Problem

in Fiscal Year 1997

Workload not materializing as planned appears to be a significant problem

again for fiscal year 1997. While the Navy ordnance business area

estimated that it would receive 6.3 million DLHs during fiscal year 1997, it

now believes that it will receive 4.7 million DLHs—a reduction of 25

percent. This has already drastically affected the operation of Navy

ordnance departments performing work. For example, in November 1996,

at one department of the Yorktown Naval Weapons Station which

employed 77 people, 33 people were charging time to overhead cost codes

even though they were originally budgeted to perform direct work.

Another department shifted 35 staff to overhead because they did not

receive work as planned. For example, this department anticipated

receiving only $5 million of the $11 million of air launch missile

maintenance work it had budgeted for in fiscal year 1997. This was a

55-percent reduction in planned workload.

Due to inaccurate forecasts of work to be performed, the Navy ordnance

business area is currently estimating that it will incur $66 million of losses

in fiscal year 1997. As discussed above, the workforce reductions have not

kept pace with the continuing decline in work. The lower-than-expected

workload levels forced the business area to shift many of its direct labor

employees to overhead positions and results in the business area

generating less revenue to cover fixed overhead costs. This, in turn, will

result in the Navy ordnance business area incurring additional losses in

fiscal year 1997. The Navy plans to reduce the Navy ordnance business

area workforce in fiscal year 1997 to better size it with its estimated

workload.

Uniform Price

Structure Is

Counterproductive to

Efficient Operations

Prior to the establishment of NOC in fiscal year 1994, each weapons station

charged customers a price for work performed that reflected the station’s

estimated costs to do the work, including a surcharge to recoup losses

from or return profits to their customers. When NOC was created, the Navy

replaced the individual station prices with a uniform price structure.

Under this structure, customers pay the same price for like work

regardless of (1) where the work is performed and (2) the individual

weapons station’s cost to perform the work. In addition, each weapons

station now shares equally in prior year losses/gains through a standard or

uniform surcharge that is included in the price charged customers. The

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Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

uniform price concept masks the individual weapons station’s

performance on the monthly financial reports.

The uniform price structure was instituted to help solidify the ordnance

business area into a single entity and is not generally used by other depot

maintenance business areas. Among other things, the Navy envisioned that

uniform prices would discourage Navy ordnance activities from competing

with each other for the same customer work and equally spread corporate

infrastructure costs over the ordnance business area’s workload.

However, the uniform price structure is not consistent with the basic tenet

of a business operation and the reasoning behind the DBOF concept: that

prices should reflect a specific activity’s actual costs of doing business.

Instead, as discussed below, the practice of using a uniform price

structure, and especially the practice of each station equally sharing

losses, distorts the true results of a weapons station’s operations and

makes it difficult for management to compare operational efficiencies

between stations and/or evaluate a station’s performance over time. It also

diminishes the incentive for a weapons station to operate efficiently.

Table 4.1 shows the disparities between individual weapons station

composite prices based on the estimated costs of doing business and the

overall NOC composite price charged customers under the uniform price

concept. For example, the Charleston Weapons Station was budgeted to

make a profit of $13.25 for every DLH of work performed because its $75.78

estimated cost per labor hour is less than the $89.03 estimated overall

composite price per hour charged customers under the uniform price

structure. Conversely, Earle was budgeted to lose $25.22 for every DLH of

work performed because the uniform price precludes Earle from

recovering its estimated costs of providing goods and services.

Table 4.1: Comparison of Individual

Weapons Station’s Composite Price

Per Hour to Overall NOC Composite

Price for Fiscal Year 1996

Weapons station

Individual

weapons station

composite price

per hour

NOC overall

composite price

per hour Difference

Earle $114.25 $89.03 $(25.22)

Yorktown 99.61 89.03 (10.58)

Concord 91.69 89.03 (2.66)

Seal Beach 81.86 89.03 7.17

Charleston 75.78 89.03 13.25

Page 40 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

The uniform price concept does not allow the ordnance business area’s

monthly financial reports to present a true picture of a weapons station’s

financial performance and thus the operational efficiency of the station.

For example, the September 30, 1996, financial reports for the ordnance

business area showed that Charleston made a profit of $10 million.

However, Charleston was budgeted to make about $44 million, which

equates to a $34 million shortfall. Because of the uniform price structure,

the monthly financial reports make it appear that Charleston was

operating efficiently because the reports showed that the station’s

revenues exceeded its expenses.

Not only does the uniform price structure distort financial reporting, the

practice of requiring each weapons station to share equally in recovering

the ordnance business area’s overall accumulated operating losses in the

prices charged customers reduces an individual station’s incentive to

operate efficiently. Fiscal year-end 1995 financial reports for the ordnance

business area showed that the weapons stations’ individual accumulated

operating results ranged from a positive $6.2 million to a negative

$90.4 million, for an overall negative accumulated operating result of

about $217 million. Regardless of what activities made a profit or incurred

a loss, NOC included a surcharge of $8.28 per DLH in the fiscal year 1996

prices that each weapons station charged its customers. As long as a

weapons station can get its high-cost operations subsidized by lower cost

stations, the incentive to reduce costs and/or operate more efficiently is

significantly diminished.

In discussing the NOC’s uniform price structure with Office of the Secretary

of Defense (Comptroller) officials, they stated that although there is no

written policy regarding the price structure to be used by business areas,

the use of a uniform price is “irregular.” Specifically, business area

activities are supposed to charge customers prices that represent their

individual operating costs plus their fair share of the business area’s

overhead. NOC officials stated that the uniform price structure tends to

mask inefficient operations and diminishes the incentive to operate

efficiently. We believe that it is time for NOC to reconsider the uniform

price structure and return to separate prices based on the individual

activity’s costs of operations.

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Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

Budgeting and

Accounting for

Overhead Costs Are

Neither Accurate Nor

Consistent

Knowing the correct cost of operations, including both overhead and

direct costs, is essential for managers to successfully manage business

operations and better control costs. However, we found that business area

managers do not have such data. Specifically, as discussed below, certain

budgeting and accounting practices make it difficult for ordnance

managers to (1) ensure that customers only pay for services they receive

or benefit from and (2) assess the business area’s performance and

determine whether it is operating efficiently.

Inaccurate Allocation of

Overhead Costs Benefits

Ammunition Storage and

Distribution Customers

The Navy ordnance business area’s overhead costs have not been properly

matched with the appropriate workloads. Specifically, tens of millions of

dollars in overhead costs related to storing and distributing ammunition

are charged to other workloads, such as engineering and maintenance. As

a result of this inaccurate allocation of overhead costs, ammunition

storage and distribution customers pay less than they should for the

services they receive, while most other customers pay more than they

should.

Navy ordnance officials are aware of this problem and, in an attempt to

properly identify cost to the benefitting customers, performed a cost

restructuring study in which they analyzed the fiscal year 1996 overhead

costs for all their major programs. The study found that a substantial

amount of the overhead costs was directly related to the weapons stations’

basic mission of providing ammunition storage and distribution services to

Navy customers. Accordingly, Navy ordnance officials have identified the

costs that would remain if all other missions were eliminated. For

example, their analysis indicates that most costs related to such overhead

functions as inventory management, explosive safety, physical security

and fire protection will remain, even if all missions other than ammunition

storage and distribution are eliminated.

The cost restructuring study concluded, among other things, that

ammunition storage and distribution customers should be charged for

about $72 million in overhead costs that are currently charged to other

customers. For example, $42 million of overhead costs related to

underutilized plant capacity was allocated to all customers even though

these costs pertain to various ammunition storage and distribution

functions such as pier usage, ammunition storage, and the maintenance of

roads and railroads used to transport the ammunition.

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Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

While the Navy has not approved this new approach, more accurately

allocating overhead costs yields two important benefits. First, it will better

match the overhead costs with the related work and, therefore, sales

prices will more accurately reflect the cost of doing the work. Secondly, it

will highlight the substantial cost associated with maintaining seven

separate Navy ammunition storage and distribution facilities.

However, if this cost restructuring initiative is implemented, the customer

would need additional appropriated funds to pay the price increases

related to the ammunition storage and distribution function. If the

customer does not receive these funds, there could be a readiness

problem. In fact, there are indications that budget constraints are already

creating problems in this area. For example, in an October 1996 message

to the business area’s Navy ammunition storage and distribution

customers, the NOC Commander pointed out that (1) as a result of budget

constraints, the Navy planned to fund only $91.8 million, or about

75 percent, of its fiscal year 1997 ammunition storage and distribution

requirement and (2) in prior years, the Navy has dealt with funding

shortfalls in this area by concentrating on loading and unloading ships,

and has neglected functions related to ammunition storage. The message

further stated that because of the funding shortfall, the Navy ordnance

business area will have problems loading ships during fiscal year 1997.

Distinction Between Direct

and Overhead Costs Is

Blurred

The Navy ordnance business area is not accurately budgeting and

accounting for costs related to railroad operations. Naval Sea Systems

Command guidance entitled NAVSEA Navy Industrial Fund Financial

Management Systems and Procedures Manual is not clear on whether train

crews should be accounted for and budgeted as overhead. One section of

the guidance provides that the labor of individual employees which can be

identifiable with a specific service or a customer order be charged to

direct labor. However, another section of the guidance specifically states

that the pay of train crews be charged to overhead.

According to NOC officials, some weapons station’s railroads are used by

more than one customer. For example, the maintenance program at a

weapons station may use the trains to transport missiles to and from

storage in performing missile maintenance work. The officials stated that

railroad personnel are classified as indirect labor primarily because it is

difficult to allocate personnel costs to the various programs when more

than one ordnance program uses the trains. However, at the Earle

Weapons Station, railroad personnel costs are considered indirect even

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Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

though the railroad only performs services for one customer—the Receipt,

Segregation, Storage, and Issue program. Specifically, Earle has 15 people

in railroad operations performing services such as locomotive engineer

and conductor. Because railroad personnel are budgeted as indirect labor,

their costs are included in the overhead costs. This has the effect of

reducing the number of DLHs charged to the customer using the railroad

but increases the hourly labor rates charged that same customer.

Consequently, it leaves managers with an inaccurate picture of the actual

labor involved in providing a service that involves the trains transporting

ordnance.

Conclusions Reliable and readily accessible financial management information is

essential to the effective and efficient operation of the Navy ordnance

business area. For a revolving fund operation, this would mean that

managers need to have accurate and consistent information on work to be

performed and that the price charged customers should reflect the cost of

doing business. However, the Navy ordnance business area (1) did not

accurately forecast the amount of work to be performed, (2) used a pricing

structure that kept individual ordnance activities from charging customers

prices that represented their estimated cost of doing business, and (3) did

not accurately and consistently budget and account for overhead costs,

especially overhead costs related to the ammunition storage and

distribution mission. These practices hamper management’s ability to

compare operational efficiencies between weapon stations, evaluate a

stations’s or the total business area’s performance over time, or reliably

estimate future operating results.

Recommendations We recommend that the Secretary of the Navy direct the Navy ordnance

business area to discontinue the uniform price structure and develop

prices for individual Navy ordnance activities.

We also recommend that the Secretary of Defense and the Secretary of the

Navy

• ensure that the workload used in developing prices at the individual Navy

ordnance activities are based on more realistic estimates by directing the

Navy ordnance business area to (1) continue to validate the workload

estimates with customers and (2) compare forecasted to actual work

(direct labor hours) received from customers and consider these trends in

developing the workload estimates and

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Chapter 4 

Effective Management and Oversight

Requires Accurate and Consistent Financial

Information

• ensure that costs, especially overhead costs associated with the

ammunition storage and distribution mission, are accurately allocated to

the customers benefitting from the services.

Agency Comments

and Our Evaluation

DOD agrees with our two recommendations to (1) ensure that workload

used in developing prices are based on more realistic estimates and

(2) ensure that costs, especially overhead costs, are accurately allocated to

the customers benefitting from the services.

However, DOD did not concur at this time with our recommendation on

setting prices based on costs expected to be incurred by individual

activities. DOD cited the need to complete two initiatives in order to more

fully consider this recommendation. DOD plans to complete these

initiatives by August 1, 1997. DOD plans to address the desirability of

establishing individual activity prices as part of a DOD-wide study to

address the concerns that the Congress has on DOD Working Capital

Funds. The second initiative involves the Navy ordnance business area

changing its method of charging ammunition storage and distribution

customers. The Navy ordnance business area now plans to charge these

customers a cost per ton instead of a cost per direct labor hour, which

may result in a more valid comparison of the costs at each ordnance

activity.

In conducting these initiatives, DOD needs to consider the incentives that

individual activities have for operating efficiently and reducing costs. With

regard to the Navy ordnance business area, we believe that as long as NOC

retains its uniform price policy, relatively high cost weapons stations will

be able to get their operations subsidized by lower cost stations and

activities, and the incentive to reduce costs and/or operate more efficiently

is significantly diminished. For example, we found that the Naval Warfare

Assessment Division (NWAD), which has less overhead costs than the

weapons stations and has operated at a profit in recent years, was required

to increase its fiscal year 1997 prices from $60.38 an hour to $76.40 an

hour, or approximately 27 percent, in order to subsidize more costly

activities. Further, if NWAD streamlines its operations and makes a profit,

the benefit of this improved efficiency on its future sales prices will be

diluted because the savings will be shared with other activities. Under the

uniform price policy, if weapons stations collectively have

higher-than-expected costs, it is possible that NWAD could streamline its

operations and reduce its operating costs, yet still have to increase its

prices.

Page 45 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I 

Comments From the Department of Defense

Page 46 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I 

Comments From the Department of Defense

Page 47 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I 

Comments From the Department of Defense

Page 48 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix I 

Comments From the Department of Defense

Page 49 GAO/AIMD/NSIAD-97-74 Navy Ordnance
Appendix II 

Major Contributors to This Report

Accounting and

Information

Management Division,

Washington, D.C.

Gregory E. Pugnetti, Assistant Director

Ron L. Tobias, Senior Auditor-In-Charge

William A. Hill, Senior Auditor

Larry W. Logsdon, Advisor

Darby W. Smith, Advisor

Cristina Chaplain, Communications Analyst

San Francisco

Regional Office

Karl J. Gustafson, Senior Evaluator

Eddie W. Uyekawa, Senior Evaluator

(511357) Page 50 GAO/AIMD/NSIAD-97-74 Navy Ordnance
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