United States General Accounting Office

GAO Report to the Honorable

Henry Bonilla, House of Representatives

February 1998 DEFENSE

OUTSOURCING

Better Data Needed to

Support Overhead

Rates for A-76 Studies

GAO/NSIAD-98-62

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-277898 

February 27, 1998

The Honorable Henry Bonilla

House of Representatives

Dear Mr. Bonilla:

The Office of Management and Budget’s (OMB) Circular A-76 and its

supplemental handbook provide policy guidance and implementation

procedures for government agencies to use in deciding whether to

contract out for commercial goods, services, and activities. As you

requested, we examined three provisions associated with a March 1996

revision to the A-76 supplemental handbook. Specifically, this report

addresses (1) what is the basis for OMB’s new requirement that a

standardized 12-percent overhead rate be applied to in-house cost

estimates, regardless of the type of commercial activity or where in the

country the activity is to be performed; (2) whether the Department of

Defense (DOD) has developed a separate overhead rate for military

personnel and, if so, the basis for that rate; and (3) how “best value”1

criteria are expected to be used in A-76 competitions. Because your

interest focused on A-76 competitions within DOD, we focused our

attention there, while gathering some data from other agencies.

Background Although a subject of increasing emphasis in recent years, federal agencies

have been encouraged, since 1955, to obtain commercially available goods

and services from the private sector through outsourcing, that is

contracting out, whenever they determine such action is cost-effective. In

1966, OMB issued Circular A-76, which established federal policy for the

government’s performance of commercial activities. Later, in 1979, OMB

issued a supplemental handbook to the circular that included the

procedures for competitively determining whether commercial activities

should be performed in-house, by another federal agency through an

interservice support agreement, or by the private sector. OMB updated this

handbook in 1983 and again in March 1996. The latest revision was

intended to reduce the administrative burden of performing A-76 studies

and to make cost comparisons between private sector proposals and

government estimates more equitable.

1

A government agency can negotiate and select an offer from the private sector that is most

advantageous to the government, considering prior performance and other noncost factors—not just

the lowest priced, acceptable offer. This “best value” private sector offer is then compared to the

government’s in-house proposal.

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To compare costs of in-house versus contractor performance, OMB’s

supplemental handbook requires the government to conduct a

management efficiency study. In this study, the government reviews its

organizational structure, staffing, and operating procedures to determine

the most efficient and effective way of performing an activity with

in-house staff. Based on this “most efficient organization” (MEO), the

government prepares an in-house cost estimate and compares it with the

best offer from the private sector. OMB’s A-76 guidance stipulates that work

will remain in-house unless the private sector offer meets a threshold of

savings that is at least 10 percent of personnel costs or $10 million over the

performance period. The minimum cost differential was established by

OMB to ensure that the government would not contract out for marginal

estimated savings.

A-76 competitions provide an important basis for achieving efficiencies

and cost savings. DOD data on cost comparisons completed between fiscal

year 1978 and 1994 shows that savings occurred—usually through a

reduction in personnel—regardless of whether the government or a

private company was awarded the work.2

 These savings were achieved

primarily by closely examining the work to be done and reengineering the

activities to do them with fewer personnel, whether in-house or

outsourced. Also, our prior work has shown the potential for significant

cost savings where military incumbency is not mission essential and

civilian personnel can be substituted for military personnel in performing

commercial-type functions.3 DOD’s data showed the government won about

half of the A-76 competitions and private industry won the other half.

Despite the benefits of competition, the A-76 process has historically been

controversial within and outside the government. Government officials

have been concerned about the cost and length of time required to

complete the procurement process associated with A-76 studies, and

employees have been concerned about the potential loss of jobs. Private

sector representatives, on the other hand, believed that the A-76 process

favored the government. They have contended that the government did not

include all costs of operations in its A-76 competitions. In particular, they

believed the government excluded proportional shares of indirect and

administrative costs such as facility maintenance and upkeep, payroll, and

personnel services.

2

Base Operations: Challenges Confronting DOD as It Renews Emphasis on Outsourcing

(GAO/NSIAD-97-86, Mar. 11, 1997).

3

DOD Force Mix Issues: Converting Some Support Officer Positions to Civilian Status Could Save

Money (GAO/NSIAD-97-15, Oct. 23, 1996).

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Consequently, OMB revised its A-76 supplemental handbook in 1996 to

improve the administration of the A-76 process and the way government

cost estimates are developed. As a result, several standard cost factors

were either changed or established, including the requirement that

government overhead costs be calculated based on a standard rate of

12 percent of direct labor costs. Because military personnel have higher

benefits and support costs than their civilian equivalents, the revised

handbook also directed DOD to develop a separate overhead rate for

military personnel to be included in any work proposals. Further, it placed

increased emphasis on consideration, during the review of private sector

offers, of the best overall value of each offer to the government.

Results in Brief Because actual cost data in government agencies have historically been

unavailable and unreliable, OMB told us it lacked meaningful information

on which to develop a standard overhead rate or to differentiate between

particular types of activities or regions of the country. Absent this data,

OMB selected a single overhead rate of 12 percent, a rate that was near the

midpoint of overhead rates suggested by government agencies and private

sector groups. Most government and private sector groups we contacted

agreed that reasonable levels of overhead should be included in A-76 cost

estimates and, absent anything better, the 12-percent rate is acceptable at

this time. In this respect, the revised handbook allows federal agencies to

develop their own rates, but to date, none have done so. While the

12-percent rate represents an appropriate move toward including

overhead costs in government cost estimates, until actual overhead costs

are captured, the magnitude of savings expected will be uncertain and the

results of A-76 studies are apt to continue to be controversial. Recent

legislation and federal management reforms emphasize the need for such

actual cost data.

Despite the requirement to develop a separate rate for military personnel

included in government in-house estimates, DOD officials that manage

commercial activity programs have no plans to develop such a rate. They

explained that, by definition, commercial activities under the A-76

program should not include any military-essential functions. Therefore,

when they prepare an in-house estimate under the A-76 program, they

assume that all military personnel currently working in the activity will be

reassigned and the activity will be staffed with civilians. Therefore, no

overhead costs for military personnel will be incurred.

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The use of “best value” procurement is an important development. While

not appropriate for use in all cases, best value helps ensure that decisions

to outsource are based on a number of important, performance-related

factors, not just cost. Recently, only the Air Force has used best-value

criteria, and only in 5 of its 15 competitions completed since March 1996.

In the future, DOD officials expect to use best-value criteria for activities

for which performance standards are particularly important, but not for

more routine tasks often associated with base support activities, such as

providing grass-cutting or dining hall services.

New Civilian

Overhead Rate Not

Supported by Actual

Cost Data

OMB required that government agencies include overhead costs in their

in-house A-76 estimates prior to the adoption of a standardized rate in

March 1996. Overhead was supposed to include two types of cost on a

marginal or proportional basis: (1) operations overhead, which includes

the costs of managing an organization that are not 100 percent attributable

to the activity under study, and (2) general and administrative costs, which

include the salaries, equipment, and work space related to headquarters

management, accounting and finance support, personnel support, legal

support, data processing support, and other common support activities

such as facilities maintenance.

Despite this guidance, OMB and DOD officials told us that overhead costs,

particularly general and administrative costs, were often not included in

the government’s estimates because they were difficult to quantify and

allocate to specific activities. These officials, as well as private sector

representatives, told us that in the few instances when agencies did

include overhead costs, they generally ranged from 1 to 3 percent of the

direct labor costs. We found this to be the case in our own examination of

available data from the Air Force, the defense activity with the greatest

number of A-76 studies in recent years. We found that only 12 of 109

in-house estimates over a period of several years included overhead costs.4

Ten of the estimates included overhead rates of 3 percent or less; two

estimates had overhead rates of 9 and 12 percent, respectively.

To respond to private sector concerns that federal agencies were not

properly recognizing overhead in their A-76 proposals and to reduce the

difficulty and burden of this requirement on agencies, OMB sought to

develop a standardized rate. OMB stated in the revised handbook that

reliable cost data is crucial to conducting A-76 competitions. However, the

4

Forty-seven of the 109 in-house estimates were for MEOs with 10 or fewer government employees.

Under these circumstances, OMB Circular A-76 criteria do not require the government’s cost estimate

to include an overhead factor.

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government’s accounting processes and commercial activity data systems5

did not contain the cost information needed by OMB to develop a standard

rate, or a rate specific to individual activities and functions or a particular

region of the country. OMB recognized this condition in the handbook,

stating that cost data has generally been unavailable and has often been

found to be unreliable.

Lacking sound empirical data on which to base an overhead rate, OMB held

discussions with various representatives from government and the private

sector to obtain their views on an appropriate rate. Proposed rates ranged

from 0 to 30 percent; the higher rates were proposed by representatives

from the private sector. An OMB official told us that further discussions

with these representatives enabled them to reach an understanding that

the extremes of this range were not realistic. For example, zero overhead

costs did not recognize any operations overhead or general and

administrative costs. And 30 percent would likely cover a full allocation of

overhead costs rather than proportionate costs. After considering the

various proposed rates, OMB decided on the 12-percent rate and included it

in a draft of what would become the March 1996 revision to the A-76

supplemental handbook.

OMB published its draft revision to the supplemental handbook in the

Federal Register in December 1995 and invited comments from interested

parties. In total, OMB received 27 responses—13 from government

organizations and 14 from the private sector. In examining these

comments, we found only 4 that commented on the proposed overhead

rate. Three of the comments were from agencies that either wanted

clarification on how the 12-percent rate was developed or wanted OMB to

allow agencies to use a different rate if it could be justified. The fourth

comment was from a private sector association that represents about 275

contractors. The association suggested agencies use a higher rate of at

least 15 percent. After considering these comments, OMB agreed to allow

agencies to use a rate different from 12 percent and included this

provision in the revised handbook. However, OMB required that before

agencies used a different rate, they would have to explain their

methodology for developing that rate in the Federal Register and subject it

to public review and comment.

5

DOD and the military services use two primary information systems to support their commercial

activities programs—the Commercial Activities Management Information System and the Commercial

Activities Inventory data base. These are not standard DOD systems. As a result, the services use a

different version of each system.

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Our discussions with government and industry representatives indicated

that the 12-percent rate was about the midpoint of the range of rates

proposed to OMB. These discussions, as well as our review of public

comments on the proposed changes to the handbook, identified no strong

opposition to the 12-percent rate. In general, government and private

sector persons we contacted tended to acknowledge that overhead costs

should be recognized and that while they might personally opt for a

different rate, the rate adopted was acceptable at that time. Only one

military service, the Air Force, had considered developing a methodology

to determine an overhead rate for its activities. However, after considering

the cost, time, and data requirements for such a study, it elected to use the

12-percent factor rather than develop its own rate.

Recent Legislative and

Management Reforms to

Capture Actual Costs

Recognizing the serious deficiency in financial and other management

information and systems across government, recent legislative and

management reform initiatives have emphasized the need for better

information, including cost data, to support federal decision-making and

measure results of program operations. Continuing efforts to implement

the Chief Financial Officers (CFO) Act are central for ensuring that

agencies resolve their long-standing problems in generating vital

information for decisionmakers. In that regard, the Federal Accounting

Standards Advisory Board (FASAB) has developed a new set of accounting

concepts and standards that underpin OMB’s guidance to agencies on the

form and content of their agencywide financial statements.6

 As part of that

effort, FASAB developed managerial cost accounting standards.7

These managerial cost accounting standards require that federal agencies

provide reliable and timely information on the full cost of federal

programs, their activities, and outputs. While there are many different

purposes for which this type of cost information may be used, the

standards focus on cost information to improve (1) federal financial

management and (2) managerial decision-making. Specifically identified in

the standards is the need for information to help guide decisions involving

economic choices such as whether to do a project in-house or contract it

out. Such information would allow for the development of appropriate

overhead rates for specific operations. The cost accounting standards

6

FASAB was created in October 1990 by the Secretary of the Treasury, the Director of OMB, and the

Comptroller General to consider and recommend accounting principles for the federal government. If

accepted by Treasury, OMB, and GAO, the standards are adopted and issued by OMB and GAO.

7

Statement of Federal Financial Accounting Standards No. 4, Managerial Cost Accounting Standards

(July 31, 1995).

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were to take effect in fiscal year 1997. However, because of serious agency

shortfalls in cost accounting systems, the CFO Council—an interagency

council that includes CFOs of the major agencies—requested an additional

2 years before the standard would be effective. FASAB recommended

extending the date by 1 year, and the standard became effective for fiscal

year 1998.

In addition, in 1996 the Congress passed the Federal Financial

Management Improvement Act (FFMIA) requiring that agency financial

management systems substantially comply with, among other things,

federal accounting standards and federal financial management system

requirements. The federal financial management system requirements

cited by the FFMIA are developed by the Joint Financial Management

Improvement Program (JFMIP)8

. Included are the Managerial Cost

Accounting System Requirements, which were issued in February 1998,

and are intended to guide federal agencies in defining their cost

accounting software requirements.

Further, the CFO Council developed The Managerial Cost Accounting

Implementation Guide. This guide, which is intended to aid federal entities

in implementing cost accounting systems, has been issued in draft and is

expected to be finalized this fiscal year.

These are all positive steps that will eventually lead to better cost data

throughout the federal government. Unfortunately, cost accounting

systems typically are not now in place and able to provide reliable cost

information to support A-76 competitions. Federal agencies must now

develop an implementation strategy, determine their system and software

needs, make appropriate modifications to, or buy new, cost accounting

systems, and implement the new standards. These actions present a

difficult challenge, particularly for an organization as large and diverse as

DOD. Moreover, as we have reported in our 1997 high-risk report,9 our

financial statement audit work has consistently identified significant

problems with the comprehensiveness and accuracy of DOD’s cost

information. While these long-standing problems are being addressed, the

solutions will take some time to implement in DOD.

8

JFMIP is a joint cooperative undertaking of OMB, GAO, the Department of Treasury, and the Office of

Personnel Management, who work together and with operating agencies to improve financial

management throughout the government. JFMIP was given statutory authorization in the Budget and

Accounting Procedures Act of 1950.

9

High-Risk Series: Defense Financial Management (GAO/HR-97-3, Feb. 1997).

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Impact of New Overhead

Rate on Recent A-76

Competitions

Prior to establishing the 12-percent overhead rate, winners of A-76

competitions in DOD were generally divided equally between the

government and the private sector. To determine how this balance might

have been affected by the new overhead rate, we asked the Air Force to

determine how the results of 33 competitions won in-house would have

changed if the 12-percent rate had been applied to its cost estimates.10 Its

analysis showed that if all other factors remained constant, 12 of the

competitions previously won by the government would have been won by

the private sector.

We also asked the Air Force to recalculate the in-house estimates for

seven Air Force A-76 competitions completed since the 12-percent

overhead rate went into effect. Private sector contractors had won six of

the seven competitions. This analysis showed that in three of the six

competitions won by the private sector, the activity would have remained

in-house if overhead rates of 0.15, 8.0, and 9.0 percent, respectively, had

been used. In the other three competitions, the in-house organizations

would have lost even if they had not included any overhead costs. This

analysis assumes, once again, that all other cost factors remained

constant. We point this out because Air Force and other military officials

told us that the 12-percent factor, along with other changes required by the

new handbook, will likely cause in-house organizations to look for new

ways to cut costs in order to remain competitive with private sector bids.

The 12-percent rate represents a proper move toward including overhead

costs in government cost estimates. However, the absence of cost data or

a methodology to support this rate leaves unclear how closely this rate

matches actual overhead costs on a site-by-site, activity-by-activity, or

agency-by-agency basis. Having a sound overhead rate is particularly

important, since DOD has recently announced plans to conduct A-76

competitions involving over 150,000 positions over the next 5 years.

Because this could involve hundreds of A-76 competitions, a standard

12-percent rate, particularly one that is not based on sound cost data, may

not be appropriate for the wide range of commercial activities in DOD. A

rate based on more realistic data would be key to mitigating concerns over

whether the government or private sector had any undue advantage in the

process.

As discussed previously, no DOD component is planning to develop rates

that are more specific to their activities, even though the supplemental

10These 33 A-76 competitions were completed between January 1990 and October 1996. We used

examples from the Air Force because it was the only military department that had readily available

cost information on its A-76 studies.

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handbook gives them this opportunity. Nevertheless, a few organizations

in DOD and elsewhere are beginning to look at how activity-based costing

might help them identify the true costs of their operations. Activity-based

costing is an analytical tool that can be used, generally in conjunction with

existing accounting systems, to identify all costs—both direct and

indirect—of providing a service or performing a function. The city of

Indianapolis, Indiana, for example, recently used this tool to obtain the

cost of its commercial activities, even though its existing accounting

systems could not provide cost data by activity.11

This tool or similar tools might be useful in helping DOD establish

appropriate overhead rates for commercial activities. For example,

overhead rates associated with aircraft maintenance may be higher than

rates associated with grass-cutting activities due to issues of complexity,

safety, and quality assurance. On the other hand, to reduce the

administrative burden of developing a rate for each commercial activity,

DOD could use these tools to develop a departmentwide rate or rates for

each military service and defense agency. Over time, extensive

reengineering of activities could also lead to lower overhead costs. This

would be the case particularly where there are large reductions in direct

labor, thus increasing the potential to significantly impact indirect costs.

DOD Has No Plans to

Develop a Separate

Military Overhead

Rate

The March 1996 A-76 supplemental handbook recognized that military

personnel are more costly to the government than civilian equivalents.

Accordingly, it required DOD activities to cost military personnel at their

respective military pay rates and develop and apply a separate rate for

them, rather than use the 12-percent rate that was to be applied only to

civilian direct labor costs. The previous edition of the handbook required

that DOD activities convert military positions to civilian ones and then cost

the positions at the civilian rate when preparing A-76 proposals.

DOD officials told us they have no plans to develop separate overhead rates

for military personnel. They explained that, by definition, commercial

activities under the A-76 program should not include any military-essential

functions. Therefore, when they prepare in-house estimates under the A-76

program, they assume that all military personnel working in the affected

activities will be reassigned and the activity will be staffed with civilians.

Given this assumption, DOD plans to continue what it described as a

long-standing policy not to include military personnel in their in-house

estimates. While DOD may exclude military personnel from activities being

11Privatization: Lessons Learned by State and Local Governments (GAO/GGD-97-48, Mar. 14, 1997).

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considered for outsourcing, it is likely that some military personnel will

continue to be used in selected overhead positions associated with the

activity. Accordingly, some level of military overhead costs are likely to be

incurred, and these costs should be appropriately reflected in overhead

costs.

Use of Best Value

Criteria in A-76

Competitions

While the supplemental handbook did not preclude the use of best value

criteria under the A-76 process, the March 1996 revision has resulted in

heightened attention to the consideration of “best overall value to the

government” in competitions. Best value criteria are considered most

appropriate when work to be competed involves higher levels of

complexity, significant technical expertise, and risk. In these situations,

the government is normally able to obtain a better value by comparing the

private sector’s technical proposals and making tradeoffs between various

technical and nontechnical factors such as past performance and costs.

Once the best private offer is selected, a comparison is made between the

private offer and the in-house estimate. To ensure that the cost

comparison is fair, the March 1996 revision specifically requires the

government to submit a technical proposal along with its other proposal

data. This allows the source selection authority12 to determine whether the

government’s technical proposal is based on the same scope of work and

performance levels as the private sector’s best value contract offer. If the

in-house proposal does not include the same level of performance, the

government is required to change its technical proposal and cost estimate

before the final comparison is made to determine the winner of the

competition.

According to DOD data, only 5 of 24 studies completed since March 1996

included best value criteria—all by the Air Force’s Air Education and

Training Command. Although different criteria can be used, each of these

studies used the following four evaluation criteria listed in order of

importance to the Command: (1) understanding the mission, (2) key

personnel, (3) mobilization and transition plans, and (4) relevant past

performance. According to Command guidance, understanding the

mission was the most important technical evaluation item. It addressed

the technical capability of the contractor in terms of how it planned to use

manpower to accomplish the mission along with supporting policies and

procedures. The contractor’s planned use of manpower was the more

12The source selection authority is the government official responsible for selecting the private sector

offer that provides the best overall value to the government and determining whether the in-house

proposal offers the same level of performance as the private sector offer.

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important factor. Key personnel addressed the quality of the offeror’s

executive and top supervisory personnel and availability dates of key

management personnel from the senior on-site manager through

supervisory levels. Mobilization was evaluated based on the offeror’s plan

to recruit staff, transfer equipment and facilities to the work site, and

phase in its workforce after the contact start date. Finally, relevant past

performance evaluated the offeror’s performance on current and

completed government contracts.

To get an indication of how the best value criteria had affected the A-76

process, we reviewed the outcome of three competitions that were

completed according to the guidelines in the revised A-76 handbook. We

reviewed documents and discussed the competitions with Air Force

officials involved in the process. These officials said that because best

value criteria requires the government to submit a technical proposal, they

were better able to compare the contractor’s winning proposal with the

government’s. In one of the studies, for example, the government was

required to adjust its proposal to match the same level of performance as

the best private offer. Although the private offeror still won the

competition, the contracting officer said she had greater confidence that

the competition was fair. In the other two studies, the source selection

authority determined that the contractor and government proposed the

same levels of performance. Consequently, the government did not have to

adjust its proposals. The government won one of the competitions and the

private offeror won the other.

We also reviewed two other competitions for which best value criteria

were considered but were not subject to the requirement that the

government submit a technical proposal, since they began prior to

March 1996 (the effective date of the new A-76 handbook). One of the

competitions—in Altus, Oklahoma—resulted in an in-house win that

required the Air Force to convert a workforce of 1,444 personnel 

(1,401 military and 43 civilians) to a workforce of 742 civilians. According

to Air Force officials, many problems have been associated with the

transition of workload at this location. We could not determine, based on

limited analysis, whether the new best value criteria, particularly the

requirement for the government to submit a technical proposal, might

have mitigated the problems resulting from this competition. However, at

the request of the Senate Armed Services Committee, we are reviewing

selected aspects of recently completed A-76 competitions—one of which

is the Altus study—in greater detail and will provide a report on our

review at a later date.

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As we have previously mentioned, over the next 5 years, DOD plans to

study more than 150,000 in-house positions under A-76. In the future, DOD

officials expect to use best value criteria when performance standards are

particularly important but not necessarily for more routine tasks, such as

providing grass-cutting or dining hall services.

Conclusions The adoption of a standard overhead rate represents a proper move

toward including overhead costs in government A-76 cost estimates.

Nevertheless, the 12-percent rate adopted by OMB lacks an analytical basis,

and its use could lead to understating or overstating overhead costs and

savings. This could be significant, particularly if DOD follows through with

its plan to subject nearly 150,000 positions to A-76 studies in the next

several years. A rate that is not analytically based could unfairly shift the

results to either the government or the private sector. Given prior DOD

overhead estimates, which usually ranged from 0 to 3 percent, the private

sector will probably be more successful in future competitions from the

use of the new 12-percent rate. We do not intend to imply, however, that a

rate of 12 percent might not be appropriate in certain circumstances or is

too high. Depending on the activity that is being competed under the A-76

process, specific rates might be higher or lower. Rather, our point is that

overhead rates that better reflect actual overhead costs are preferable and

would promote fairer competition between the government and private

sector.

As we point out in the report, however, it will likely be many years before

FASAB cost standards are fully implemented in DOD and capable of

producing accurate and reliable cost data. For this reason, we believe DOD,

with OMB’s encouragement and assistance, should develop a methodology

for determining a more appropriate interim overhead rate or range of rates

for use in its A-76 competitions. This methodology could make appropriate

use of activity based costing or similar tools to estimate rates on either a

departmentwide, military service, or commercial activity basis, depending

on how DOD chooses to develop its rates. This process would not require

an adjustment in the most recent A-76 Supplemental Handbook because

the Handbook already gives agencies the option of developing a separate

overhead rate if it better reflects the costs of operations. By exercising this

option, DOD would be developing interim rates that are more accurate and

that promote fairer competition, regardless of whether the rate goes up or

down. Over the long-term, the more extensive reengineering of DOD

business activities through the A-76 process could lead to lower overhead

costs. This would be the case, particularly where reductions in direct labor

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are large, thus increasing the potential for significantly impacting indirect

costs.

Despite the requirement to develop a separate overhead rate for military

personnel included in government in-house proposals, DOD officials

indicated they do not plan to do so. This is based on DOD’s policy to

reassign military personnel and only use civilians in commercial activities

being subjected to A-76 competition. However, some military personnel

will continue to be used in selected overhead positions and as such some

level of military overhead costs are likely to be incurred.

Although the concept and use of best value criteria are not new, the

emphasis on them has increased, primarily because it gives the

government the opportunity to consider other important factors besides

cost. In particular is the new requirement that the government submit a

technical proposal as part of its in-house estimate. To date, best value

criteria have received limited use within DOD under A-76, but their use

could grow in the future with DOD’s increased emphasis on outsourcing

competitions. We believe this is a useful approach to better ensure

commonality of work being proposed between in-house and private sector

offerors.

Recommendation We recommend that the Director of the Office of Management and Budget

and the Secretary of Defense work together to develop a methodology that

will determine an appropriate interim overhead rate or range of rates for

DOD commercial activities. The methodology needs to have an analytical

base and include appropriate indirect overhead costs as well as general

and administrative costs identified in the A-76 supplemental handbook.

The methodology also needs to consider the cost of military personnel that

may be in the various categories of overhead costs and the unique nature

of individual business activities being assessed. Once OMB and DOD agree

on a methodology, OMB should consider its applicability to civilian

agencies.

Agency Comments

and Our Evaluation

OMB generally agreed with the report’s findings. However, OMB strongly

disagreed with our conclusion that the lack of a detailed analytical basis

leaves open to question the fairness of the A-76 process. It pointed out that

the 12-percent overhead rate strengthens the cost comparison process by

being both administratively and economically reasonable. Given this

condition, OMB said it was not clear whether it can or should require the

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development of more accurate overhead figures. Further, OMB said that the

12-percent overhead factor has always been treated as an interim solution

and asked that we recognize the work that is being done by the FASAB, the

CFOs Council, and others to develop better data that would eventually be

used in government financial statements and to support A-76 studies.

While it did not comment on the report’s findings, DOD said that it fully

supported OMB’s efforts to streamline the A-76 process and that the

development of a standard overhead rate was a key component of that

effort. Without a standard rate, DOD said it would have to calculate

overhead costs for each A-76 study, which it did not believe made good

management sense. Consequently, DOD disagreed with our

recommendation and said it has no plans to develop a specific DOD-only

overhead rate or rates. However, DOD said it is prepared to work with OMB

if OMB decides to make additional revisions to A-76 procedures.

We agree with OMB that a standard overhead rate reduces the

administrative burden associated with conducting cost comparisons,

which was one of OMB’s goals in revising the A-76 handbook. We have no

basis to judge, however, the economic reasonableness of the 12-percent

rate adopted by OMB. As we point out in the report, the rate lacks an

analytical basis and may or may not reflect actual overhead costs. Because

this could unfairly shift the results of the competition to either the

government or the private sector, we think it is important for OMB and DOD

to develop a methodology to determine an overhead rate(s) more

appropriate for DOD. Contrary to DOD’s view, this methodology does not

have to be burdensome or costly to implement, nor does it have to reflect

the overhead rates of every activity being assessed under the A-76 process.

Such a methodology could be developed on a military service, defense

agency, or DOD-wide basis. As we point out in the report, using a rate that

better reflects actual overhead costs is important because DOD has

announced plans to use the A-76 process to study about 150,000 positions

over the next 5 years.

As suggested by OMB, we included a section in the report to reflect the

work that has been done by FASAB, the JFMIP, and the CFO Council to

develop management cost accounting standards, system requirements, and

implementing guidance that, once fully implemented by DOD and others,

will enable agencies to identify reasonable overhead rates for their A-76

studies. The Managerial Cost Accounting Standards, which became

effective at the beginning of fiscal year 1998, are aimed at providing

reliable and timely information on the full cost of federal programs, their

Page 14 GAO/NSIAD-98-62 Defense Outsourcing
B-277898 

activities, and outputs and should help agencies begin to make tangible

progress toward developing improved cost accounting systems. The

adoption of these standards, however, is only the first step in a potentially

long process at DOD. Because of the poor condition of DOD’s financial

systems, it will likely be many years before DOD can fully implement and

take full advantage of more reliable cost data. For this reason, and

considering the large number of A-76 studies that DOD may conduct before

the cost standards are fully implemented, we continue to believe that OMB

and the Secretary of Defense should work together to develop a

methodology for an overhead rate or range of rates for DOD—one having

an analytical underpinning that can be further refined as more reliable cost

data becomes available.

Our scope and methodology are discussed in appendix I. Appendix II

provides a detailed description of the A-76 process. DOD’s and OMB’s

comments are reprinted in their entirety in appendix III and IV,

respectively, as well as our comments on specific points.

We are sending copies of this report to the Chairmen of the Senate

Committees on Armed Services and on Appropriations and the House

Committees on National Security and on Appropriations; the Secretaries

of Defense, the Air Force, the Army, and the Navy; and the Director of OMB.

We will make copies available to others on request.

Please contact me at (202) 512-8412 if you or your staff have any questions

concerning this report. Major contributors to this report were Barry

Holman, James Hatcher, James Fuquay, and Cheryl Andrew.

Sincerely yours,

David R. Warren, Director

Defense Management Issues

Page 15 GAO/NSIAD-98-62 Defense Outsourcing
Contents

Letter 1

Appendix I 

Objectives, Scope,

and Methodology

18

Appendix II 

The A-76 Process

22

Appendix III 

Comments From the

Office of Management

and Budget

27

Appendix IV 

Comments From the

Department of

Defense

31

Figure Figure II.1: Overview of the A-76 Process 23

Abbreviations

CFO Chief Financial Officer

DOD Department of Defense

FASAB Federal Accounting Standards Advisory Board

FFMIA Federal Financial Management Improvement Act

IFB invitation for bids

JFMIP Joint Financial Management Improvement Program

MEO most efficient organization

OMB Office of Management and Budget

RFP request for proposals

Page 16 GAO/NSIAD-98-62 Defense Outsourcing
Page 17 GAO/NSIAD-98-62 Defense Outsourcing
Appendix I 

Objectives, Scope, and Methodology

As requested, we examined three provisions associated with a March 1996

update to the A-76 supplemental handbook. Specifically, we examined

(1) what is the basis for a new A-76 requirement that a standardized

12-percent overhead rate be applied to in-house estimates, regardless of

the type of commercial activity being studied or where in the country that

activity is to be performed; (2) whether the Department of Defense (DOD)

has developed a separate overhead rate for military personnel and, if so,

the basis for that rate; and (3) how “best value” criteria are expected to be

used in A-76 competitions.

To determine the basis for how the Office of Management and Budget

(OMB) developed the civilian overhead rate of 12-percent of direct labor

costs, we held discussions with OMB officials in charge of rewriting the

supplemental handbook. We initially asked for empirical data that would

provide an analysis and support for the development of a rate. We were

advised that the government did not have enough useful data for OMB to

develop the rate. Therefore, OMB considered the views of various private

sector and government representatives before setting the rate. Because

OMB had not retained any records supporting discussions with these

representatives, we contacted the following government and private sector

organizations to verify that they had discussions with OMB regarding an

appropriate civilian overhead rate and to discuss their views about the

12-percent overhead rate:

GOVERNMENT SECTOR

• Office of Secretary of Defense, Arlington, Virginia

• Department of the Air Force, Arlington, Virginia

• Department of the Army, Arlington, Virginia

• Department of the Navy, Arlington, Virginia

• U.S. Marine Corps, Arlington, Virginia

• Defense Logistics Agency, Fort Belvoir, Virginia

• Center for Naval Analysis, Arlington, Virginia

• Defense Finance and Accounting Service, Arlington, Virginia

• Defense Information Systems Agency, Arlington, Virginia

PRIVATE SECTOR

• Contract Services Association, Washington, D.C.

• American Operations Corporation, Tysons Corner, Virginia

• American Federation of Government Employees, Washington, D.C.

Page 18 GAO/NSIAD-98-62 Defense Outsourcing
Appendix I 

Objectives, Scope, and Methodology

In government sector organizations, we met with the organizational

component responsible for the commercial activities program. We also

reviewed the public comments OMB received after publishing a draft

version of the revised supplemental handbook in the Federal Register. In

total, we reviewed 27 comments—13 from government organizations and

14 from private industry. Only one association recommended a rate

different from 12 percent. We met with representatives of that group and

found that they did not have any support for the higher rate.

We also surveyed the military services, selected DOD agencies, and selected

civilian agencies of the federal government to determine the number of

A-76 studies that have been completed or initiated since the March 1996

handbook revisions were issued. Where agencies had completed or had

ongoing studies, we identified those that used best value criteria to

evaluate contractor proposals. We did not attempt, however, to validate

the accuracy of this survey information. In addition to the DOD components

identified above, we contacted the

• Agency for International Development

• Department of Agriculture

• Department of Commerce

• Department of Education

• Department of Energy

• Department of Health and Human Services

• Department of Housing and Urban Development

• Department of Interior

• Department of Justice

• Department of Labor

• Department of Transportation

• Department of the Treasury

• Environmental Protection Agency

• General Services Administration

• National Aeronautics and Space Administration

• Office of Personnel Management

• Social Security Administration

• United States Information Agency

Within DOD, the Air Force has, by far, conducted the preponderance of

A-76 studies during the last several years. Also, the Air Force is the only

military service that captures overhead costs related to the in-house

estimates in its Commercial Activities Management Information System.

Page 19 GAO/NSIAD-98-62 Defense Outsourcing
Appendix I 

Objectives, Scope, and Methodology

We found limited efforts underway in the civilian agencies to initiate new

A-76 studies—only two studies were ongoing. These studies are underway

at the Department of Agriculture and the Department of Commerce.

Among the civilian agencies we contacted, we identified only two A-76

competitions that had been completed since the handbook revisions were

implemented; both were best value competitions. Therefore, our analysis

of completed studies focused almost entirely on DOD and the Air Force.

We asked the Air Force’s Innovation Center located at Randolph Air Force

Base, Texas, to analyze all studies completed between 1990 and

March 1996 to determine what would have happened to the outcome of all

competitions won by Air Force units if an overhead rate of 12 percent of

direct labor costs had been applied in their in-house estimates. This

analysis involved 33 Air Force competitions that were conducted from the

beginning of fiscal year 1990 until the 12-percent rate was implemented in

March 1996. We also looked at the results of seven studies that had been

completed since the 12-percent rate was implemented and asked the

Innovation Center to determine the outcome of those competitions if the

12-percent rate had not been used. We documented the methodology used

by the Innovation Center to conduct these analyses. However, we did not

verify the Center’s calculations.

To determine the status of the military services’ development of a military

overhead rate to be used in A-76 competitions, we contacted each military

service’s office in charge of commercial activities. In each instance, we

were told that no overhead was being developed. We requested DOD’s

policy statement on this issue but found that DOD has no written policy

addressing the elimination of military personnel from government

proposals during A-76 competitions.

To determine how best value criteria are expected to be used in A-76

competitions, we held discussions with officials from each military

service’s commercial activities office to find out the types of activities to

which best value criteria might be applied and visited the Air Force

Materiel Command at Wright-Patterson Air Force Base, Ohio, and the Air

Education and Training Command at Randolph Air Force Base, Texas. We

also asked each of the military services to provide documentation on the

number of competitions they had completed since 1996. In addition, we

asked them to identify the number of these competitions that used the

negotiated, best value method. We were able to identify five studies that

involved the use of best value criteria. Two of the studies were completed

prior to the issuance of the revised supplemental handbook. The other

Page 20 GAO/NSIAD-98-62 Defense Outsourcing
Appendix I 

Objectives, Scope, and Methodology

three studies were competed under the rules of the revised supplemental

handbook, which required the government to submit a technical proposal

with its estimates.

We held discussions with the contracting officers and reviewed

documentation for each of the best value contracts to determine the

evaluation criteria used to select the best private offer, the number of

offers received from private industry, the process used to evaluate the

offers, the rationale for selecting other than the low cost offeror, the

rationale for any adjustments to the in-house proposal, the winner of the

competition, and the savings expected from the competition. Since these

studies had just been completed in the last 6 months, it was too soon for

us to determine whether the estimated savings would be achieved.

We performed our work from July to December 1997 in accordance with

generally accepted government auditing standards.

Page 21 GAO/NSIAD-98-62 Defense Outsourcing
Appendix II 

The A-76 Process

In general, the A-76 process consists of six key activities. They are

(1) developing a performance work statement and quality assurance plan;

(2) conducting a management study to determine the government’s most

efficient organization (MEO); (3) developing an in-house government cost

estimate for the MEO; (4) issuing a request for proposals (RFP) or invitation

for bid (IFB); (5) evaluating the proposals and comparing the in-house

estimate with a proposed contract or interservice support agreement and

selecting the best proposal; and (6) addressing any appeals submitted

under the administrative appeals process, which is designed to ensure that

all costs are fair, accurate, and calculated in the manner prescribed by the

A-76 handbook.

Figure II.1 shows an overview of the process. The solid lines indicate the

process used when the government issues an IFB, requesting firm bids on

the cost of performing a commercial activity. This type of process is

normally used for more routine commercial activities, such as

grass-cutting or cafeteria operations, where the work process and

requirements are well defined and enough potential contractors are

available to support a competitive procurement. The dotted lines indicate

the additional steps that take place when the government wants to pursue

a negotiated, best value procurement. This type of process is used when

competition is limited and/or the commercial activity involves higher

levels of complexity, expertise, and risk.

Page 22 GAO/NSIAD-98-62 Defense Outsourcing
Appendix II 

The A-76 Process

Figure II.1: Overview of the A-76 Process

Issue performance 

work statement 

and RFP or IFB

Compare selected 

Best Value and MEO

technical proposals

Government 

Technical 

Evaluation 

Activities

Prepare in-house 

cost estimate

Revise

MEO 

Revise 

in-house cost

estimate 

MEO 

Activities

Compare 

costs/select 

contractor

MEO activities

 Government technical evaluation activities

Conduct most efficient 

organization (MEO)

management study

Select lowest

cost alternative

Additional steps required for request 

for proposals (RFP)

Process for invitation for bid (IFB)

Prepare technical

proposal

Conduct technical 

evaluation of MEO

Conduct technical

evaluation of 

bids/proposals

Accept 

contractor

bids/proposals

Source: Air Force Air Education and Training Command documents.

Page 23 GAO/NSIAD-98-62 Defense Outsourcing
Appendix II 

The A-76 Process

As with all A-76 competitions, the circular requires the government to

develop a performance work statement. This statement, which is

incorporated into either the IFB or RFP, serves as the basis for both

government estimates and private sector offers. If the IFB process is used,

each private sector company develops and submits a bid, giving its firm

price for performing the commercial activity. While this process is taking

place, the government activity performs a management study to determine

the most efficient and effective way of performing the activity with

in-house staff. Based on this most efficient organization, the government

develops a cost estimate and submits it to the selecting authority. The

selecting authority concurrently opens the government’s estimate along

with the bids of all firms that are judged to be technically qualified to

perform the statement of work. According to OMB’s A-76 guidance, the

government’s in-house estimate wins the competition unless the private

sector’s offer meets a threshold of savings that is at least 10 percent of

direct personnel costs or $10 million over the performance period. This

minimum cost differential was established by OMB to ensure that the

government would not contract out for marginal estimated savings.

If the RFP—best value process—is used, federal procurement regulations

and the A-76 supplemental handbook require several additional steps. The

government and private sector offerors submit proposals that include a

management plan, technical performance proposal, and cost estimate.

While the government’s proposal must be based strictly on the

performance work statement, private sector proposals can be based on a

higher level of performance or service.

The government’s selection authority reviews the private sector proposals

to determine which one represents the best overall value to the

government based on such considerations as (1) higher performance

levels, (2) lower proposal risk, (3) better past performance, and (4) cost to

do the work. After the completion of this analysis, the selection authority

prepares a written justification supporting its decision. This includes the

basis for selecting a contractor other than the one that offered the lowest

price to the government. Next, the authority evaluates the government’s

technical proposal and determines whether it can achieve the same level

of performance as the selected private sector proposal. If not, the

government must then make changes to meet the performance standards

accepted by the authority. This ensures that the in-house cost estimate is

based upon the same scope of work and performance levels as the best

value contract offer. After determining that the offers are based on the

same level of performance, the cost estimates are compared. As with the

Page 24 GAO/NSIAD-98-62 Defense Outsourcing
Appendix II 

The A-76 Process

IFB process, the work will remain in-house unless the private offer is 

(1) 10 percent less in direct personnel costs or (2) $10 million less over the

performance period. Participants in the process—for either the IFB or RFP

process—may appeal the selection authority’s decision if they believe the

costs submitted by one or more of the participants were not fair, accurate,

or calculated in the manner prescribed by the A-76 handbook. Appeals

must be submitted in writing within 30 days of the decision and are

supposed to be adjudicated within 30 days after they are received.

Recent Examples of Best

Value Type A-76

Competitions

Following is information on the three recent best value competitions, all of

which were conducted by the Air Education and Training Command using

the best value guidelines established in the revised supplemental

handbook:

At Tyndall Air Force Base, Florida, aircraft maintenance, civil engineering,

and supply/fuels activities were included in the A-76 study. Four private

sector firms submitted a total of 10 proposals. (Contractors were allowed

to submit offers on one or more of the activities). After reviewing the

proposals, the source selection authority selected the low-cost offer as the

best overall value to the government. The authority then reviewed the

in-house management plan and determined that the government proposal

needed to be adjusted to the same level of performance as the private

sector offer. After the adjustment was made, the cost estimates were

reviewed, and a contractor won the competition. Air Force officials

estimate that this competition will allow it to eliminate 1,017 personnel

authorizations.

The Laughlin Air Force Base, Texas, A-76 study dealt with regionalizing jet

engine repairs. We found that three private sector offers were considered

by the source selection authority to compete against the in-house

proposal. The authority chose a private offer that was not the low cost

offer. In the justification for selecting this offer, the authority stated,

among other things, that the winning contractor offered a “sound

organizational structure and a solid understanding of the mission at a very

reasonable price.” After reviewing the in-house management plan, the

authority did not believe the in-house performance proposal needed to be

adjusted because it satisfied the requirements of the solicitation at the

same level of performance as the selected private offeror. The cost

estimates were then reviewed, and the private offeror won the

competition. As a result, Air Force officials estimate that 48 personnel

authorizations will be eliminated.

Page 25 GAO/NSIAD-98-62 Defense Outsourcing
Appendix II 

The A-76 Process

Another study was completed at Columbus Air Force Base, Mississippi, for

civil engineering, supply, and transportation activities. Six private sector

organizations submitted a total of 14 proposals. The source selection

authority selected two of these proposals, each of which were deemed the

best value for a portion of the work, as finalists in the competition.1

 Next,

the source selection authority reviewed the government’s technical

proposal and decided that it provided the same level of performance as the

best private proposals. Finally, the cost estimates were reviewed, and the

function was retained in-house. We reviewed a formal protest from one of

the private sector competitors and upheld the Air Force’s decision to

retain the activity in-house.2

 Air Force officials expect this competition to

yield a 34-percent reduction in personnel by eliminating 114 positions.

1

In this competition, two private sector organizations competed against the in-house offer. Unlike the

private sector, however, the in-house organization had to include all activities collectively. Either the

in-house organization retains all of the activities or they are contracted out to one or more private

sector organizations.

2

Madison Servs., Inc., B-277614, Nov. 3, 1997, 97-2 CPD__¶

Page 26 GAO/NSIAD-98-62 Defense Outsourcing
Appendix III 

Comments From the Office of Management

and Budget

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment 1.

See comment 2.

See comment 3.

Page 27 GAO/NSIAD-98-62 Defense Outsourcing
Appendix III 

Comments From the Office of Management

and Budget

Now on p. 8.

See comment 4.

Now on p. 12.

See comment 5.

See comment 6.

See comment 3.

Page 28 GAO/NSIAD-98-62 Defense Outsourcing
Appendix III 

Comments From the Office of Management

and Budget

The following are GAO’s comments on the OMB’s letter dated January 13,

1998.

GAO Comments 1. We agree that the A-76 cost comparison process was designed to

enhance competition, not just to study whether an activity should be

contracted out. As we point out on page 2, the A-76 supplemental

handbook includes “procedures for competitively determining whether

commercial activities should be performed in-house, by another federal

agency through an interservice support agreement, or by the private

sector”. Nevertheless, in most cases, the A-76 process is used by federal

agencies to determine whether a commercial activity currently performed

by the government can be performed more cost-effectively by the private

sector. This creates a competitive environment that has traditionally

driven down the cost of performing the activity, whether it is retained

in-house or contracted-out to the private sector. This is how we have

described the A-76 process in the report.

2. We agree with OMB that savings from A-76 studies result from a wide

range of factors and modified the report accordingly. Our work has

consistently shown, however, that A-76 studies are cost-effective,

primarily because they result in a reduction in personnel. In addition, DOD

captures only personnel-related savings. DOD generally knows, for

example, how many people performed the activity before and after the

A-76 competition. They do not always know other historical costs and

consequently are unable to calculate savings associated with other types

of improvements.

3. The agency comments section in the report addresses this issue. Also,

on page 6 of the report, we have added a section that recognizes the work

of the FASAB and CFO Council.

4. Our intent in including this analysis in the report was to give the reader

some perspective on how the 12-percent standard rate might have affected

A-76 competitions, both before and after the rate became a requirement.

We believe this is a logical question most people would want to know. We

agree with OMB that the results of the analysis is not surprising—it is

logical that more private sector organizations would have won the

competitions if the government used a 12-percent overhead rate since little

or no overhead costs were included in most studies. The analysis shows

the extent to which this might happen, if all other factors were to remain

constant. However, considering the subjective nature of the 12-percent

Page 29 GAO/NSIAD-98-62 Defense Outsourcing
Appendix III 

Comments From the Office of Management

and Budget

rate, we have no basis to determine if it “improves the playing field,” as

OMB suggests. Logically, it improves the competitive position of private

sector offerors and, as OMB points out, could encourage more of them to

participate in the process.

5. The report does not conclude that the 12-percent overhead rate is both

reasonable and appropriate. Rather the report concludes that the

development of a standard rate is a proper move toward making sure that

overhead costs are included in the government’s A-76 cost estimates. It is

clear throughout the report, however, that our view is that the 12-percent

rate, which lacks an analytical basis, could understate or overstate

overhead costs and unfairly shift the competition results to either the

government or private sector.

6. We do not believe the report understates the importance of good data or

the need to ensure fairness in the process. Rather, it is a desire to see a

more fair process that led to our conclusions and recommendation.

Likewise, because good data is obviously important to the A-76 process,

our recommendation encourages OMB to work with DOD and other agencies

to develop a more data-based methodology for calculating overhead rates.

While it is true that DOD lacks standardized financial systems and cost data,

it nonetheless has large amounts of financial data that it uses regularly to

manage programs, estimate costs, and develop budgets. Developing some

type of methodology to use this information, even with its limitations, is

preferable, in our view, to relying on one standard rate that is applied

across the government regardless of the agency or type of activity being

studied. Moreover, we believe that a sound methodology will further

enhance public and private offerors’ perceptions that the A-76 process is

fair and reasonable.

Page 30 GAO/NSIAD-98-62 Defense Outsourcing
Appendix IV 

Comments From the Department of Defense

See comment 1.

See comment 2.

Page 31 GAO/NSIAD-98-62 Defense Outsourcing
Appendix IV 

Comments From the Department of Defense

The following are GAO’s comments on DOD’s letter dated January 29, 1998.

GAO Comments 1. The agency comments section in the report addresses this issue.

2. As we point out in the report, we believe military personnel costs should

be recognized in DOD overhead rates because military personnel generally

cost more than their civilian counterparts. While some military personnel

assigned to overhead functions may deploy to support mobilization

requirements, many do not. Therefore, we believe military personnel costs

need to be a component of DOD overhead rates.

(709283) Page 32 GAO/NSIAD-98-62 Defense Outsourcing
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