United States General Accounting Office

GAO Report to Congressional Committees

August 1995 DEFENSE

RESTRUCTURING

COSTS

Payment Regulations Are

Inconsistent With

Legislation

GAO/NSIAD-95-106

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-259594 

August 10, 1995

The Honorable Strom Thurmond

Chairman

The Honorable Sam Nunn

Ranking Minority Member

Committee on Armed Services

United States Senate

The Honorable Floyd Spence

Chairman

The Honorable Ronald V. Dellums

Ranking Minority Member

Committee on National Security

House of Representatives

Section 818 of the National Defense Authorization Act for Fiscal Year 1995

sets out certain requirements governing payments made by the

Department of Defense (DOD) to its contractors for costs associated with

business combinations, including mergers and acquisitions. Normally,

after a business combination, a new company will undertake restructuring

activities such as closing facilities, eliminating jobs, and relocating

employees.

Section 818 prohibits payment of restructuring costs until a senior DOD

official certifies that projected savings from the business combination are

based on audited cost data and should result in overall reduced costs to

DOD. Section 818 also requires the Secretary of Defense to report annually

on DOD experience with business combinations, including whether savings

associated with each restructuring actually exceed costs.

In response to section 818 requirements, DOD issued interim regulations on

restructuring costs effective December 29, 1994. As required by the

statute, we reviewed the regulations to determine whether they (1) are

consistent with section 818, applicable procurement laws, and the Federal

Acquisition Regulation (FAR) and (2) ensure that restructuring costs are

paid only when in the best interests of the United States.

Results in Brief DOD’s regulations do not comply with section 818 requirements because all

restructuring costs associated with defense contractor business

combinations, for which contractors may be reimbursed, will not be

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B-259594 

subject to the section’s certification requirements. The exclusion of costs

from the section’s certification requirements is due to a distinction DOD

makes in types of restructuring activities. By excluding some restructuring

costs that should be subject to section 818 certification requirements, DOD

will not be able to ensure that the payment of these costs are made only

when in the best interests of the United States.

In addition, the regulations do not contain a mechanism to ensure that DOD

will be able to meet the section’s annual reporting requirement to the

Congress. Moreover, DOD plans to pay restructuring costs up to the amount

of savings projected to result from a business combination, which would

result in the payment of those costs without significant projected savings

to DOD.

Background Contractors historically have not been permitted to recover restructuring

costs through contracts that were transferred from one contractor to

another in connection with a business combination. The rationale was that

the government should not pay increased contract costs that were

incurred only because the contractor decided to combine with another

firm.

In July 1993, DOD changed its long-standing practice of not paying

restructuring costs. The change, made after several major defense

contractors approached DOD, was intended to encourage contractors to

consolidate and thereby reduce operating and contract costs. The change

allowed contractors to charge DOD for costs incurred in connection with a

business combination if such costs were permitted by the FAR1

 and if a DOD

contracting officer determined that a business combination would result in

overall reduced costs or preserve a critical defense capability.

The Congress enacted section 818 the following year, prohibiting payment

of restructuring costs until a senior DOD official certifies that projections of

savings have been audited and that the savings should result in overall

reduced costs to DOD. The Congress also required the Secretary of Defense

to issue implementing regulations by January 1, 1995, and submit annual

reports on restructuring activities during 1995-97.

1

The FAR contains guidelines for determining whether a particular cost is an allowable charge to a

government contract. Costs associated with business combinations that are specifically identified as

unallowable in the FAR include legal and consulting fees.

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B-259594 

DOD’s Regulations

Exclude Some

Restructuring Costs

From Section 818

Certification

Requirements

DOD’s regulations do not comply with section 818 requirements because

they do not require all costs associated with a business combination to be

subject to the section’s certification requirements. In its regulations, DOD

defines two kinds of “restructuring activities”—internal and external.

• Internal activities are those occurring after a business combination that

involve the facilities or workforce of only one of the companies involved

in the business combination. These restructuring costs, even if associated

with the business combination, would not be subject to the certification

requirements of section 818.

• External activities are those occurring after a business combination that

involve facilities or workforces from both of the previously separate

companies. The costs associated with external activities would be subject

to section 818 certification requirements.

Section 818 makes no such distinction but addresses the allowability of

restructuring costs regardless of whether the facilities or workforces from

both or only one of the previously separate companies were involved. The

operative condition in section 818 is that the restructuring costs be

“associated with” the business combination.

The significance of the distinction made by DOD between internal and

external restructuring activities is illustrated by the following example

offered by one of the military services. Assume that Company A purchases

Company B and that both companies operate similar test laboratories.

Assume further that as a result of the business combination, Company A

eliminates its laboratory facilities and workforce. Although Company A

would not have closed its laboratory without the business combination,

under DOD’s interim regulations, the restructuring activity would be

defined as internal and thus excluded from the required certification

because the facilities and workforce of only one of the two previously

separate companies were involved. By excluding these “internal” costs,

DOD will not be capturing all restructuring costs subject to section 818 and,

therefore, will not be able to determine whether the savings from the

business combination result in an overall reduced cost to DOD.

Accordingly, DOD will not be able to ensure that restructuring costs are

paid only when in the best interests of the United States.

Page 3 GAO/NSIAD-95-106 Defense Restructuring Costs
B-259594 

Regulations Do Not

Require Data Needed

to Respond to Annual

Reporting

Requirements

DOD’s regulations do not address section 818’s requirement for the

Secretary of Defense to report annually to the Congress on its experience

with business combinations, including whether the savings associated

with restructuring activities exceed the costs. It is questionable whether

DOD can prepare such a report without using contractor cost and savings

data because DOD is not independently collecting such data. According to

DOD officials, there are no plans at this time to require contractors to

submit data that would show that actual savings exceed restructuring

costs paid by DOD. Without such data, the Congress will have no assurance

that its decision to permit the payment of restructuring costs only in

limited circumstances is actually resulting in overall reduced costs to DOD.

DOD Would Pay

Restructuring Costs

Without Significant

Projected Savings

In a July 1994 congressional hearing, the Deputy Secretary of Defense

testified that restructuring activities in the defense industry were expected

to result in significant benefits to DOD—with savings exceeding costs by as

much as 7 times. The Deputy Secretary also testified that DOD should not

pay restructuring costs unless it was absolutely sure that savings would

exceed costs. According to senior DOD officials, DOD now plans to pay

restructuring costs up to the amount of the savings projected to result

from the business combination, thus resulting in the payment of these

costs without significant projected savings to DOD. A senior DOD official

said that payments should be made to contractors even if overall reduced

costs do not result because such payments would encourage an orderly

downsizing in a defense industry that currently has excess capacity and

DOD would benefit in the long run.

Recommendations We recommend that the Secretary of Defense

• revise the regulations to make clear that all restructuring costs associated

with a business combination, whether involving internal or external

activities, are subject to section 818 certification requirements and

• determine how DOD will comply with the annual congressional reporting

requirement, and if contractor data is necessary for compliance,

incorporate such data collection requirements in DOD’s regulation.

Agency Comments

and Our Evaluations

In commenting on a draft of this report, DOD said that it would revise the

definitions of internal and external restructuring activities to clarify that

activities affecting the operations of both previously separate companies

are external activities. DOD concurred that it should have a workable plan

Page 4 GAO/NSIAD-95-106 Defense Restructuring Costs
B-259594 

for collecting data required for the section 818 requirements and stated

that it would issue a memorandum to cognizant Defense Contract

Management Command and Military Department activities setting forth

the methods for complying. (Subsequent to commenting on a draft of this

report, DOD issued the memorandum, which we have not reviewed for

compliance with section 818 requirements.)

A draft of this report contained a third recommendation that DOD develop

an implementation plan to comply with section 818’s requirement that

restructuring costs be paid only if projected savings from a business

combination should result in overall reduced cost to DOD. In commenting

on the draft report, DOD stated that it has not seen and does not anticipate

situations where costs exceed savings and would not pay costs in excess

of savings in the unlikely event that costs were greater. Accordingly, we

deleted the recommendation. We will monitor restructuring payments and

savings in the future.

DOD indicated that it did not agree with our statement that in 1993 DOD

changed its long-standing practice of not paying restructuring costs.

Although the FAR provides contracting officers with the flexibility to

negotiate appropriate terms on transferred contracts, our observation that

a change in practice occurred was based on documents signed by senior

DOD officials and interviews. For example, an April 9, 1993, letter from the

Commander, Defense Contract Management Command, stated that

current standard language in the FAR prevented any increased costs on

transferred contracts and suggested that a review of DOD policy in this area

may be warranted. The Under Secretary of Defense for Acquisition’s

July 21, 1993, response stated that restructuring costs should be allowed

and the standard language be revised if there were projected savings. DOD

officials told us that increased costs had not been allowed on transferred

contracts before the July 1993 letter.

DOD’s comments are presented in their entirety in appendix I.

Scope and

Methodology

We discussed various aspects of restructuring activities with officials from

the Offices of the Assistant Secretary of Defense for Economic Security;

the Director of Defense Procurement; the Secretaries of the Army, the Air

Force, and the Navy; the Cost Accounting Standards Board; the Defense

Contract Management Command; the Defense Contract Audit Agency; and

the DOD Inspector General.

Page 5 GAO/NSIAD-95-106 Defense Restructuring Costs
B-259594 

We compared other procurement laws, applicable regulations, and 

section 818 and its legislative history to DOD’s interim regulations and

examined various proposals, documents, reports, and other records

related to restructuring activities by defense contractors. We also

examined comments by potentially affected parties as the interim

regulations were being formulated and after they were issued. We

examined various documents, reports, and other records relative to

specific restructuring activities by several defense contractors. In addition,

we visited a contractor involved in a business combination and examined

information related to restructuring projects resulting from the

combination.

We performed our review between September 1994 and May 1995 in

accordance with generally accepted government auditing standards.

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

Committee on Governmental Affairs and the House Committee on

Government Reform and Oversight; the Secretaries of Defense, the Army,

the Air Force, and the Navy; the Administrator, Office of Federal

Procurement Policy; the Commander, Defense Contract Management

Command; and the Director, Defense Contract Audit Agency. We will

provide copies to other interested parties upon request.

Please contact me at (202) 512-4587 if you or your staff have any questions

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

appendix II.

David E. Cooper

Director, Acquisition Policy, Technology,

 and Competitiveness Issues

Page 6 GAO/NSIAD-95-106 Defense Restructuring Costs
Page 7 GAO/NSIAD-95-106 Defense Restructuring Costs
Contents

Letter 1

Appendix I 

Comments From the

Department of

Defense

10

Appendix II 

Major Contributors to

This Report

15

Abbreviations

DOD Department of Defense

FAR Federal Acquisition Regulation

Page 8 GAO/NSIAD-95-106 Defense Restructuring Costs
Page 9 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix I 

Comments From the Department of Defense

See p. 2.

Page 10 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix I 

Comments From the Department of Defense

See p. 3.

Page 11 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix I 

Comments From the Department of Defense

See p. 5.

Page 12 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix I 

Comments From the Department of Defense

See p. 4.

Page 13 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix I 

Comments From the Department of Defense

See p. 4.

See p. 5.

See p. 5.

Page 14 GAO/NSIAD-95-106 Defense Restructuring Costs
Appendix II 

Major Contributors to This Report

National Security and

International Affairs

Division, Washington,

D.C.

John K. Harper

Office of General

Counsel, Washington,

D.C.

William T. Woods

Roger H. Ayer

Atlanta Regional

Office

George C. Burdette

Kelly A. Davis

(705078) Page 15 GAO/NSIAD-95-106 Defense Restructuring Costs
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