United States General Accounting Office

GAO Report to the Secretary of Defense

December 1997 DEFENSE

ACQUISITION

Guidance Is Needed on

Payments for

Conditionally Accepted

Items

GAO/NSIAD-98-20

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-278211 

December 12, 1997

The Honorable William S. Cohen

The Secretary of Defense

Dear Mr. Secretary:

During prior work on the C-17 program, we noted that the Air Force

generally accepted aircraft with incomplete or deficient work, on the

condition that the contractor complete the work after delivery.1

 Although

the Air Force withheld payment for the work not done, the amounts

withheld were less than the estimated cost and profit to complete this

work. We conducted this review to determine if this situation occurred on

other programs and if additional guidance was needed to avoid paying

contractors for work not done at the time of delivery.

Background When acquiring goods or services by contract, U.S. government policy is

generally to pay only for completed work. The purpose of this policy is to

reduce the government’s risk of financial exposure in the event a

contractor fails to perform. In the case of payments at the time of

conditional acceptance, this would generally mean withholding sufficient

funds to cover the estimated cost and profit associated with completing

the work. This policy of only paying for completed work is grounded in the

prohibition against advance payments contained in title 31, section 3324 of

the United States Code, which states that “a payment under a contract to

provide a service or deliver an article for the United States Government

may not be more than the value of the service already provided or the

article already delivered.” This policy is also evident in the provisions

governing progress payments,2

 which state that agencies “shall ensure that

any payment for work in progress . . . is commensurate with the work

accomplished. . . .”3

 The statutory exceptions to this policy apply

conditions or restrictions to the transaction. For example, a written

determination is required from the head of an agency, or his or her

designee, that the use of advance payments is in the public interest.

1

Conditional acceptance means that a contracting officer has determined that it is in the government’s

best interest to accept an item that does not conform to contract specifications or is otherwise

incomplete with the expectation that the contractor will later correct nonconformances or complete

other work.

2

Progress payments are a method of interim contract financing in which the government and a

contractor share the financial burden of contract performance.

3

41 U.S.C. 255(e)(1) and 10 U.S.C. 2307(e)(1).

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These policies are implemented in the Federal Acquisition Regulations

System. This system consists of the Federal Acquisition Regulation (FAR),

which is the primary authority, and agency acquisition regulations that

implement and supplement the FAR. The Department of Defense’s (DOD)

implementing regulation is the Defense Federal Acquisition Regulation

Supplement (DFARS). In addition, each of the military services’ acquisition

organizations has issued supplemental guidelines for use in implementing

policies and procedures in the FAR and the DFARS.

According to the FAR, contracting officers normally should reject supplies

and services that do not conform to contract specifications. However, FAR

section 46.407 (Nonconforming Supplies or Services) provides exceptions

for those circumstances (such as for reasons of economy or urgency) in

which accepting such supplies or services may be in the government’s best

interest. This section addresses only situations when the government has

decided to accept items with permanent nonconformances and not require

a contractor to correct the deficiencies after delivery. In these situations,

the FAR recommends that the contract be modified to reduce the price or

provide other consideration to reflect that the items are less than were

specified in the contract.

Results in Brief Our review of four selected Air Force, Army, and Navy acquisition

programs showed that each of the services accept items conditionally.

However, federal and DOD regulations do not provide guidance to

contracting officers for determining amounts to be withheld from

payments in these cases. We also found that there is no consensus among

Office of the Secretary of Defense and service officials as to what policy

should govern payments at the time of conditional acceptance. Some

officials agreed that the amount withheld should reflect the estimated cost

and profit associated with the work to be done by a contractor after

delivery while others indicated that contracting officers should have

discretion to withhold whatever amount they determine appropriate.

The extent of service guidance ranged from the Army providing no

guidance to standard Air Force and Navy contract clauses that leave

determining the amount to be withheld to the contracting officer’s

discretion. Such guidance does not ensure that the amount withheld

reflects the estimated cost and profit to correct known deficiencies and

perform other incomplete work. As a result, it lacks the safeguards

necessary to reduce the government’s risk of financial exposure and is

inconsistent with the policy of paying only for completed work.

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B-278211 

Our review of the four selected acquisition programs showed that when

items were conditionally accepted, each of the services paid contractors

the billing price, assuming 100-percent completion, less some amount for

nonconforming or unfinished work. In general, the amounts withheld were

less than the costs to correct known deficiencies and complete unfinished

work and resulted in contractors being paid for work that had not been

performed at the time of conditional acceptance. For example, the

estimated price to correct known deficiencies and complete unfinished

work on two C-17 production contracts exceeded the amounts withheld by

about $61 million, based on the contractor’s cost estimates, or $127 million

based on the cost estimates used by the Defense Contract Management

Command (DCMC) in administering the contract. The Hunter Unmanned

Aerial Vehicle program accepted five systems with six conditional waivers

for which no money was withheld. Program officials told us that they

believed the contractor would correct the deficiencies. The program office

was not able to provide an estimate of the potential cost of this work.

The DFARS should be amended to provide departmental guidance on the

amounts to be withheld in cases of conditional acceptance by the services.

This amendment should require that the amount withheld when

conditionally accepting nonconforming items reflect at least a reasonable

estimate of the cost to correct known deficiencies and to do other

incomplete work remaining at the time of delivery. If a contracting officer

determines that withholding a lesser amount would be in the best interests

of the government, the determination should be accompanied by

safeguards adequate to protect the government’s interests.

Guidance on

Conditional

Acceptance of Items

Is Not Adequate

The FAR and the DFARS do not provide guidance for withholding payment

for work to be performed after delivery in situations where the

government conditionally accepts nonconforming or incomplete work.

Moreover, within the military acquisition community, no consistent way

has been developed for determining whether payments should be withheld

or how to determine the amount to withhold.

The DOD Director of Defense Procurement told us that a contracting officer

should withhold from payment the estimated cost and profit for work to

be done by the contractor after delivery. However, Air Force and Army

acquisition officials told us that while the cost and profit of the remaining

work should be a consideration, the amount withheld, if any, should be left

to the discretion of the contracting officer.

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B-278211 

Air Force supplemental guidance includes a standard contract clause

allowing contracting officers to use their discretion in determining the

amount to be withheld. The Army provides no supplemental guidance to

the FAR for use in conditionally accepting items and establishing a

withhold amount. At the Naval Sea Systems Command and the Naval Air

System Command (NAVAIR) procurement and contracting officials agreed

that amounts withheld should directly relate to the anticipated cost of

work to be performed by a contractor after delivery. However, contract

clauses that the two commands use give a contracting officer authority to

withhold a lesser amount.

From 1981 through 1992, the Air Force Materiel Command’s (AFMC)

Aeronautical Systems Division supplements provided for a standard

contract clause entitled “Correction of Supplies Accepted With

Deficiencies,” which called for withholding 10 percent of the price when

conditionally accepting items. The clause allowed a contracting officer to

use a higher or lower percentage as conditions warranted.

In July 1997, AFMC revised this clause and left the determination of the

amount withheld to the contracting officer’s discretion. The revised clause

provides a list of factors to consider when deciding on a withhold amount,

including (1) the cost to correct the deficiencies; (2) any loss of value to

the government due to reduced reliability, increased life-cycle costs, or

reduced availability; and (3) any other factors that may affect government

use or cost of ownership.

In ship construction and conversion contracts, the Naval Sea Systems

Command uses a standard payment clause that requires a contracting

officer to withhold a percentage of the contract price when a ship is

conditionally accepted. The clause provides for withholding, as a

performance reserve, the greater of either 1.5 percent of the contract price

or $100,000. This clause also provides that a contracting officer may

withhold more than the 1.5 percent if he or she finds that the standard

withhold amount is insufficient to cover the cost to correct deficiencies or

complete unfinished work. The NAVAIR standard clause entitled

“Acceptance Under Fixed-Price Contracts” allows a contracting officer,

under certain conditions, to accept nonconforming items and to withhold

an amount, as he or she determines appropriate.

A policy that would require the withholding of at least the estimated cost

and profit in this circumstance or require written justification for an

exception would protect the government’s interests and be consistent with

Page 4 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

the treatment accorded payments for work that has not been completed in

other instances. For example, FAR, subpart 32.4, which implements the

advanced payment statutes, requires that approval of a contracting

officer’s recommendation for an advance payment be based on a written

determination by an approving official that such advance payment is in the

public interest or facilitates the national defense.

Inadequate Withholds

Result in Contractors

Being Paid for Work

Not Completed

Our review of four selected acquisition programs indicated that each of

the services conditionally accepted nonconforming items, with the

expectation that the contractors would correct known deficiencies and

complete unfinished work. When conditionally accepting nonconforming

items, each of the services paid contractors the billing prices, assuming

100-percent completion, less some amount that was withheld for

nonconforming or unfinished work. The services differed in how they

determined the withhold amounts, but in each case, the amounts were less

than the estimated costs to correct known deficiencies and complete

unfinished work. As a result, the contractors were paid for work not yet

done.

Air Force’s C-17 Program To meet the need for additional long-range airlift, the Air Force contracted

with the McDonnell Douglas Corporation, which later merged with the

Boeing Company, to develop and produce 120 C-17 aircraft. As of

October 1997, the contractor had delivered 34 production aircraft, all of

which were conditionally accepted by the Air Force with a number of

waivers and deviations that required corrective action by the contractor.

We reviewed the adequacy of amounts withheld for eight aircraft

conditionally accepted under two contracts for fiscal years 1990 and 1992,

production lots III and IV, respectively. At the time of last aircraft delivery

for each lot, the Air Force had withheld a net amount of about $47 million

for problems with such things as computer software and assembly

workmanship and for certain components on which qualification testing

had not been completed. However, the amount withheld was significantly

less than the estimated cost to correct known deficiencies and finish other

incomplete work.

Both contracts stipulated that the contracting officer should withhold a

minimum of 10 percent of the contract price when conditionally accepting

aircraft until the contractor completed the corrective actions. The lot IV

contract, however, allowed the contracting officer to deviate from this

requirement and withhold a lesser amount. C-17 program officials stated

Page 5 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

that they did not believe 10 percent was reasonable given the aircraft’s

high price. Therefore, starting with lot III, instead of withholding

10 percent of an aircraft’s billing price, the program office and the

contractor agreed to categorize waivers and deviations and establish

standard withhold amounts for each category. In addition, they agreed to

negotiate specific amounts for unique nonconformances. However, the

program office did not modify the C-17 contracts to incorporate this

withhold policy.

Program officials told us that the withhold policy implemented in the C-17

program was not intended to cover the estimated cost and profit of the

work remaining to be done by the contractor after conditional acceptance.

They said that withholds were intended only to be an incentive to the

contractor to correct deficiencies and finish other incomplete work.

Table 1.1 compares our estimate of what should have been withheld after

the delivery of the last aircraft in each lot with the amounts actually

withheld. Our review indicated that the cost and profit to correct

deficiencies and complete unfinished work for production lots III and IV

exceeded the $47 million withheld by about $61 million, based on the

contractor’s estimates of the cost of the aircraft at completion, or about

$127 million, based on DCMC’s estimates of the cost of aircraft at

completion.4

 The final aircraft of lots III and IV were accepted in February

and August 1994, respectively. At the time of our review, the contractor

was correcting deficiencies and completing unfinished work.

4

These cost estimates were in effect at or shortly after the delivery of the last aircraft in each lot.

Page 6 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

Table 1.1: Estimates of Unearned Cost

and Profit Paid at the Time of Last

Aircraft Delivery for C-17 Production

Lots III and IV Contractor’s estimate at

completion

DCMC’s

estimate at completion

Based on:

Dollars in millions

Lot III Lot IV Total Lot III Lot IV Total

Price paid at

deliverya $1,202.9 $1,131.6 $1,202.9 $1,131.6

Less

overpayment in

priceb 22.0 13.2

Adjusted price 1,109.6 1,118.4

Less earned cost

and profit at

delivery 1,136.7 1,067.2 1,082.5 1,064.1

Unearned cost

and profit 66.2 42.4 120.4 54.3

Less amount

withheld 29.0 18.3 29.0 18.3

Unearned

amount paid at

delivery $37.2 $24.1 $61.3 $91.4 $36.0 $127.4

aIncludes only aircraft contract line items.

bThe contractor was overpaid due to the government’s failure to decrease the billing price to

reflect a transfer of engineering costs from the lot IV contract to the development contract. The

amount of overpayment also depends on whether the contractor’s or government’s cost estimate

is used to compute an adjusted billing price.

Army’s Tactical Vehicles

Program

The Army established the Family of Medium Tactical Vehicles (FMTV)

program to replace its aging fleet of 2.5-ton and 5-ton trucks and vans. The

Army plans to purchase about 85,000 FMTV vehicles over a 30-year period.

In October 1991, the program office awarded a $1.2-billion contract to

Stewart and Stevenson Services, Inc., for the initial production of 

10,843 trucks and vans over 5 years. In August 1996, the program office

revised the contract to procure these vehicles over a 7-year period. As of

June 1997, the contract price to produce 11,197 trucks and vans was

$1.36 billion.

The contractor produced 3,040 vehicles during the program’s low-rate

initial production phase. Nearly all of these vehicles (2,936) required a

retrofit after production to resolve problems. These problems had been

Page 7 GAO/NSIAD-98-20 Defense Acquisition
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identified prior to acceptance during early testing.5 The government

conditionally accepted 1,941 of these vehicles prior to retrofitting them.

Many of these vehicles required an extensive retrofit effort, dismantling

them down to the frame.

The program office applied three different payment withholds, related to

retrofit requirements, against the 1,941 vehicles. One withhold was for

parts that were missing when the trucks were conditionally accepted. A

second was imposed on vehicles accepted before the completion of first

article testing, and a third involved deficiencies in the contractor’s quality

control system. These withholds were released to the contractor after

each vehicle had been retrofitted and accepted by the government.

The second withhold was required by the contract’s conditional

acceptance clause. This clause required that 10 percent of the billing price

be withheld for those vehicles conditionally accepted prior to completion

and approval of first article testing. The 10-percent figure was negotiated

between the program office and the contractor. It did not bear any

relationship to a projected cost estimate for retrofitting delivered trucks

after testing was completed. A contracting officer with the U.S. Army

Tank-Automotive and Armaments Command (TACOM) said that this clause

was included in the FMTV contract based on experience with the previous

M939A2 5-ton truck program.6

The third withhold was implemented later in the program because of

government concerns that the vehicles did not conform to contract

specifications because of inadequate contractor quality control. In July

1995, the program office modified the contract’s conditional acceptance

clause to require an additional withhold amount on program year 1 and 

2 vehicles. It involved withholding $2,000 for each vehicle built prior to

April 11, 1994, and $1,000 for each vehicle built on or after this date. FMTV

program officials were unable to provide an analytical basis for the two

withhold amounts. Contracting files indicated that this withhold was

implemented as an incentive to the contractor to improve his quality

control system, thereby reducing the government’s risk in conditionally

accepting vehicles.

5

The remaining 104 vehicles were produced when the other vehicles were being retrofitted, and the

modifications were incorporated during production.

6

In that program, the contractor, which had been paid the full price, was required to retrofit about

2,500 trucks to correct nonconformances found during testing. The contractor was planning to do the

retrofit work during breaks in new truck production or at the end of the program. TACOM officials

convinced the contractor that leaving the retrofit work until the end would not be acceptable.

Page 8 GAO/NSIAD-98-20 Defense Acquisition
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DCMC had estimated that the cost could be as high as $24 million to retrofit

vehicles but had not developed a detailed estimate that we could use to

evaluate the reasonableness of the amounts withheld. However, on the

basis of the actual costs to retrofit these vehicles, we estimated the cost to

retrofit the 1,941 vehicles conditionally accepted and compared that

estimate to the amounts withheld related to the retrofit. As shown in table

1.2, we estimated the cost to retrofit the 1,941 vehicles exceeded the

amounts withheld by about $2 million. At the time of our review, the

retrofit required at the time of conditional acceptance had been

accomplished.

Table 1.2: Estimate of Unearned Costs

Paid for Vehicles Conditionally

Accepted Prior to Retrofit

Dollars in millions

Number of

vehiclesa Cost

Less

withhold

amount

Unearned

amount paid

at delivery

Retrofitted 2,917 $32.0a

Accepted but not retrofitted 19 0.2

Total requiring retrofit 2,936 32.2

Less: vehicles not accepted

prior to retrofit 995 9.6

Conditionally accepted prior

to retrofit 1,941 $22.6 $20.6a $2.0

aActual.

Navy’s Conversion of

Commercial Container

Ships

To improve the Military Sealift Command’s prepositioning and surge

sealift programs, the Navy is converting commercial container ships into

roll-on roll-off sealift ships. Three ships are being converted under a

contract with the National Steel and Shipbuilding Company. We reviewed

the adequacy of the payment withholds for one of these ships, the USNS

Shughart, which the Navy conditionally accepted on May 7, 1996. The

contract for these ships contained the standard Naval Sea Systems

Command clause that provides for a 1.5-percent performance reserve at

the time of conditional acceptance but allows for a greater withhold as

determined necessary by the contracting officer.

At the time of the USNS Shughart’s conditional acceptance, the Navy

project officer recommended withholding about $10.3 million for critical

incomplete work and other deficiencies. However, there was only about

$9.5 million available to withhold from the ship’s $289.7 million billing

price because the Naval Sea Systems Command, with appropriate higher

Page 9 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

approval, had already released $5 million in prior progress payment

retentions to the contractor. Accordingly, the project officer

recommended and the contracting officer withheld the $9.5 million. At the

time of our review, the contractor had generally completed work and

corrected deficiencies identified at the time of conditional acceptance.

Joint Tactical Unmanned

Aerial Vehicle Program -

Hunter System

The Hunter Unmanned Aerial Vehicle (UAV) is a small, fixed-wing aircraft

piloted remotely from a ground control station. The Hunter system, a part

of the Joint Tactical UAV program, began in 1989 as a joint service effort to

provide short-range UAVs for use by the Army, the Navy, and the Marine

Corps. The Hunter system contract is administered by NAVAIR. In February

1993, this command exercised contract options with TRW, Incorporated,

for the low-rate initial production of seven Hunter systems. In

January 1996, DOD decided to end the Hunter Program at the end of the

low-rate initial production contract.

Between April and August 1995, the government conditionally accepted

five Hunter systems, and it has since accepted, on an incremental basis,

the remaining two systems. The cumulative billing price for the five

complete systems was about $128.5 million. From this, the government

withheld about $1.6 million for missing parts, nonconforming items, and

other incomplete work.

Although the contracting officer withheld payment for the above noted

work, he did not withhold for other deficiencies. The contracting officer

had issued 34 separate contractual waivers to prevent acceptance delays

because the systems did not conform to contract specifications. Six of

these waivers were temporary in nature and were approved on the

condition that corrective action would be taken after delivery. These

waivers involved hardware and software problems, subcontractor

workmanship deficiencies, and incomplete work.

The contracting officer did not withhold from the billing price the

estimated cost to correct these deficiencies because program officials

believed that the contractor was committed to correcting the deficiencies.

However, not withholding funds based on the belief that the contractor

will perform requires the government to assume a major risk in the event

of nonperformance and is not consistent with a policy that requires paying

only for completed work. Because the system had been terminated, we

were unable to readily determine the status of the unfinished work. In

commenting on a draft of this report, DOD stated that the contractor has

Page 10 GAO/NSIAD-98-20 Defense Acquisition
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since corrected the six deficiencies and the government has accepted, on a

final basis, all of the systems.

Conclusion and

Recommendations

When the government chooses to conditionally accept nonconforming

items, the FAR, the DFARS, and supplementary service regulations do not

require that an amount sufficient to cover the remaining work be withheld

from the contract payment. As a result, the services’ withholding practices

are inconsistent and contractors are being paid for work not completed at

the time of delivery.

We recommend that the Secretary of Defense amend the DFARS to require

that, when conditionally accepting nonconforming items, amounts

withheld be at least sufficient to cover the cost and related profit to

correct deficiencies and complete other unfinished work. If the

contracting officer determines that withholding a lesser amount is in the

best interests of the government, such a determination should be properly

documented and justified in the contract files.

Agency Comments

and Our Evaluation

DOD generally concurred with the report’s findings, however, it only

partially concurred with our recommendation. DOD agreed that the DFARS

should be changed to include a requirement that when conditionally

accepting nonconforming items, amounts to be withheld should at least

cover the cost and related profit to correct deficiencies and complete

unfinished work. DOD did not agree that the contracting officer should be

required to obtain higher level approval before deviating from this general

policy. DOD’s comments are reprinted in appendix I. Technical comments

have been addressed in the report as appropriate.

While we continue to believe that certain safeguards would help ensure

adherence to the policy of only paying for work that is completed, revising

the DFARS to specifically include the requirement is a good first step toward

achieving this goal. DOD assumes that departure from the prescribed

standard would be rare. We do not have information on a sufficient

number of programs to address DOD’s assumption. Accordingly, we have

modified our recommendation to delete the requirement for higher level

approval of decisions to depart from the prescribed standard. We continue

to believe, however, that requiring such departures to be justified and

documented in the contract file will facilitate further oversight of this

issue as needed.

Page 11 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

Scope and

Methodology

We reviewed the FAR, the DFARS, and supplementary service regulations

regarding conditional acceptance of nonconforming items. We also spoke

with the DOD Director of Defense Procurement and with acquisition and

contracting officials from the Departments of the Air Force, the Army, and

the Navy and the Defense Logistics Agency located in Washington, D.C., to

determine their policies and procedures for accepting temporarily

nonconforming items.

We selected four acquisition programs that had entered low- or full-rate

production to obtain coverage of Air Force, Army, Navy, and joint service

programs. In addition, our selections were based on the size of the

programs and the availability of documentation on the acceptance

process. We reviewed contract files, billing and delivery documentation,

and cost data. To gain an understanding of how conditional acceptance

was implemented in each of the services, we interviewed contracting and

procuring officials with the (1) C-17 program office in Dayton, Ohio;

(2) FMTV program office located at the Army’s Tank-Automotive and

Armaments Command in Warren Michigan; (3) Supervisor of Shipbuilding

and Conversion in San Diego, California; and (4) Joint Tactical UAV project

office at Redstone Arsenal, Alabama. We also discussed management of

the various contracts with contracting personnel at the DCMC offices

located at the Boeing Company in Long Beach, California; TRW Avionics

and Surveillance Group in San Diego, California; and Stewart and

Stevenson Services, Inc., in Sealy, Texas.

Because we confined our review to defense programs, we have limited our

recommendation to the DFARS. However, we will provide copies of this

report to the FAR Council, the group responsible for approving changes to

the FAR, for their consideration.

Page 12 GAO/NSIAD-98-20 Defense Acquisition
B-278211 

Please contact me at (202) 512-4841 if you or your staff have any questions

concerning this report. Major contributors to this report are listed in

appendix II.

Sincerely yours,

Louis J. Rodrigues

Director, Defense Acquisitions Issues

Page 13 GAO/NSIAD-98-20 Defense Acquisition
Appendix I 

Comments From the Department of Defense

Page 14 GAO/NSIAD-98-20 Defense Acquisition
Appendix II 

Major Contributors to This Report

National Security and

International Affairs

Division, Washington,

D.C.

Thomas J. Denomme

Noel J. Lance

Carlos M. Garcia

Dorian R. Dunbar

John A. Carter

(707227) Page 15 GAO/NSIAD-98-20 Defense Acquisition
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