United States General Accounting Office

GAO Report to the Secretary of Defense

January 1995 DEFENSE SUPPLY

Inventories Contain

Nonessential And

Excessive Insurance

Stocks

GAO/NSIAD-95-1

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-258425 

January 20, 1995

The Honorable William J. Perry

The Secretary of Defense

Dear Mr. Secretary:

The Department of Defense (DOD) stocks hundreds of millions of dollars of

what it calls insurance items to ensure that the operational capability of a

weapon system is not compromised. These items are mission essential

spare parts and supplies that are not expected to fail through normal

usage. They include aircraft parts such as doors, rudders, and ejection

seats. DOD regulations state that only one replacement unit of an item may

be stocked for insurance purposes.

We reviewed the Navy’s and the Defense Logistics Agency’s (DLA)

management of insurance items. Our objectives were to determine if

insurance stocks were limited to (1) mission essential parts and (2) one

replacement unit as required by DOD regulations.

Background DOD inventory control points are responsible for managing insurance

items. We performed our review at the Aviation Supply Office (ASO), one of

two Navy inventory control points, and the Defense Industrial Supply

Center (DISC), one of six DLA inventory control points. As of March 1994,

ASO managed insurance inventories valued at $193 million and, as of

April 1994, DISC managed insurance inventories valued at $3 million.

Spare parts and other supplies normally are designated as insurance items

during the initial provisioning process. Initial provisioning is designed to

provide parts until there is a requisitioning history from which relatively

accurate forecasts of future demands can be made. Typically, these parts

support a weapon system during the first 2 years of operation. At ASO,

contractors or manufacturers recommend which parts should be stocked

for insurance purposes, ASO reviews these recommendations, and the

Naval Air Systems Command approves the recommendations if it agrees

with the contractor and ASO. DISC classifies items on the basis of

submissions by the using military service during the initial provisioning

process.

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B-258425 

Results in Brief ASO and DISC stock millions of dollars of unnecessary insurance items. Most

are not mission essential and frequently are stocked in quantities greater

than one unit. ASO records show that only about 10 percent of the

insurance items are mission essential. We questioned the managers of a

sample of these items, and they stated that about 22 percent are mission

essential. Similarly, DISC records indicate that only about 42 percent of

their insurance items are mission essential. We also questioned DISC

managers, but none had responded to the questionnaire at the time our

fieldwork was completed. Furthermore, contrary to DOD regulations, both

ASO and DISC stock about one half of the insurance items in quantities

greater than one unit.

The unnecessary inventories occurred because ASO and DISC do not

periodically review insurance items to ensure that they are mission

essential and stocked in appropriate quantities. It costs DOD millions of

dollars each year to manage and maintain these unnecessary inventories.

Most Insurance Items

Are Not Mission

Essential

We analyzed ASO and DISC records to identify insurance items and

determine if they were properly classified. We found that most of the items

were not mission essential and, therefore, should not have been classified

as insurance items. Table 1 summarizes the results of our analysis.

Table 1: Analysis of Insurance Items on ASO and DISC Records

ASO DISC

Item classification Number Percent Cost Number Percent Cost

Fully justified as insurance item 1,042 10.5 $65,917,000 1,410 42.3 $1,694,000

Not mission essential, should not

be insurance item

8,118 81.7 109,466,000 325 9.7 222,000

Insurance item justification was

not determined

777 7.8 17,749,000 1,600 48.0 841,000

Total 9,937 100.0 $193,132,000 3,335 100.0 $2,757,000

Because only a small percentage of the insurance items were fully justified

in the inventory control point records, we asked item managers to verify

the classification of the insurance items. We randomly sampled 329 ASO

items and 110 DISC items and sent questionnaires to item managers asking

them to validate the records. According to the ASO item managers

surveyed, 51 percent of the items were not mission essential. Table 2

summarizes the sample results.

Page 2 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

Table 2: Summary of Sample Results

From ASO Item Managers Item classification Number Percent

Fully justified as insurance item 73 22

Not mission essential, should not be

insurance item

169 51

Insurance item justification could not be

determined

42 13

Questions not answered 45 14

Total 329 100

We did not make a similar analysis for DISC because none of the item

managers had responded to the questionnaire at the time our fieldwork

was completed.

Essentiality Is Not

Validated

Significant numbers of nonessential parts and supplies continue to be

stocked as insurance items because ASO and DISC do not have the internal

controls to periodically review insurance items to identify those that are

unneeded because they do not meet essentiality criteria. As noted in tables

1 and 2, only 10.5 percent of ASO’s insurance items were mission essential

according to ASO records and only 22 percent were mission essential

according to item manager responses to our questionnaire. At DISC,

42.3 percent were mission essential according to its records.

ASO assigns mission essentiality codes on the basis of reports from end

users on how the failure of a part affects mission capability. These codes

range from one where item failure results in minor mission impact to one

where item failure results in loss of a primary mission capability. DISC

assigns essentiality codes, called weapon system indicator codes, on the

basis of data provided by the using military service.

Neither ASO nor DISC systematically reviews insurance items to validate the

essentiality codes. ASO does require an annual review to ensure that the

data elements used to prevent automatic purchases of insurance items are

correctly loaded in the computer. However, this review does not verify

that insurance items are mission essential. DISC does not require a review

of insurance item essentiality.

The absence of essentiality reviews contributed significantly to the low

percentage of mission essential items identified in our review. In addition

to the 22 percent ASO item managers said were mission essential, they

indicated that 51 percent of the insurance items were not mission essential

Page 3 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

and that they either could not or did not determine essentiality for the

remaining 27 percent. The following examples illustrate the error

conditions identified.

ASO stocks three skin assembly units used on the AV-8B aircraft as

insurance items. These units, which are valued at a total of $158,927, have

a nonessential coding in ASO’s records. In responding to our questionnaire,

the item manager agreed with the coding in the record and indicated that

the units were not mission essential. These assemblies have been in the

Navy supply system since the weapon system was provisioned in 1986.

In another case, ASO stocks 12 manual control levers used on the F/A-18

aircraft as insurance items. These levers, which are valued at a total of

$997,020, have been in the supply system since 1983. Again, the item

manager indicated that the lever, although categorized as an insurance

item in the records, was not mission essential.

Excessive Quantities

Are Stocked

Although DOD Material Management Regulation 4140.1-R, dated

January 1993, states that only one replacement unit of an item may be

stocked for insurance purposes, we found that ASO and DISC stocked many

of the insurance items in quantities greater than one unit. This condition

was true for both mission essential items and nonessential items. At ASO,

4,997 insurance items, valued at $126 million, or 50 percent, of the 

9,937 insurance items were stocked in quantities greater than one unit. Of

the 1,042 mission essential items included in these totals, 510 items had

excessive quantities valued at $49 million. At DISC, 1,602, or 48 percent, of

the 3,335 insurance items were stocked in quantities greater than one unit,

including 784 of 1,410 mission essential items.

The reasons for the excessive quantities are similar to the reasons that

nonessential items are stocked as insurance items. That is, much of the

excessive buildup occurred during the initial provisioning process. DOD

downsizing and weapon system obsolescence and retirement also

contributed to the stock buildup. However, neither ASO nor DISC has

established the internal controls to periodically review insurance items to

ensure that quantities are kept at the allowable stock level of one unit.

An additional factor contributing to the excessive quantities is the

inventory control points’ stock retention policies. ASO and DISC have

computer programs to identify and recommend excess stock for disposal.

ASO programs search for stocks in excess of retention levels and are run

Page 4 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

for all stocked items, not just insurance items. However, irrespective of

retention levels, the programs will not recommend disposal action on

quantities that fall below a floor of five units at ASO. The DISC programs

identify disposal prospects on a selective basis and have not been run for

insurance items.

The computer programs have not been effective in reducing excess

insurance stocks at ASO for two major reasons. First, contrary to DOD

regulations, ASO has established retention levels for many insurance items

that exceed the allowed stockage quantity of one unit. Second, the

requirement that any disposal recommendation leave an on-hand quantity

of five units precludes reducing the stockage level to one unit. As a result,

only 330 of the 4,997 insurance items that we found to be overstocked

were identified as such by ASO’s computer program.

The following examples illustrate the overstockage conditions identified.

ASO stocks 20 aircraft seat structures used on the A-7 aircraft as insurance

items. These structures, which are valued at a total of $2,559,586, have

been in the supply system since 1979. In responding to our questionnaire,

the item manager indicated that 14 of these units were removed from

aircraft as a result of design changes and were unserviceable. The

remaining six units were serviceable but exceeded the allowed insurance

stock level of one unit.

In another case, ASO stocks two electrical equipment racks used on the

E-2C aircraft as insurance items. These racks, which are valued at a total

of $687,480, exceed the allowed insurance stock level of one unit but will

not be reviewed for potential disposal because the quantity falls below

ASO’s on-hand stockage floor of five units. The item manager agreed that

the racks were in an excess position but would not recommend this item

for disposal because of the on-hand stockage floor.

Holding Costs Are

High

In addition to unneeded procurement costs, DOD incurs large costs to

manage and maintain excess inventories, particularly items with low

demand or years of supply on hand. DOD expresses these holding costs as a

percentage of the value of on-hand inventory. Holding costs include

investment cost, or the cost of having funds tied up in inventory; storage

costs; and obsolescence costs. The holding cost rate varies by inventory

control point and averages 22 percent at ASO and 18 percent at DISC.

Page 5 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

In commenting on our draft report, DOD stated that the holding cost rates

we used may be correct before a purchase decision is made, but once

material is in inventory the risk of obsolescence is represented as a sunk

cost and the opportunity to spend the funds on an alternative investment

has been foregone. DOD also stated that the holding cost rates that should

have been applied for material in stock is at least an order of magnitude

less than the rates used in the report.

DOD did not give an alternative percentage or amount and DOD’s accounting

systems are not designed to capture actual holding costs. In commenting

on another report (GAO/NSIAD-94-110, June 29, 1994), DOD agreed that

unnecessarily large inventories increase holding costs and acknowledged

that holding cost rates that only cover storage costs may not be

appropriate. For example, reducing inventories by quantities sufficient to

close warehouses would result in savings that exceed storage costs.

While it is difficult to precisely determine the costs to manage and

maintain nonessential and excessive insurance stocks, our review and

DOD’s comments indicate that these costs would be millions of dollars a

year.

Recommendations We recommend that the Secretary of Defense direct the Secretary of the

Navy and the Director, Defense Logistics Agency, to (1) periodically

review insurance items to ensure that they are mission essential and

stocked in allowable quantities and (2) dispose of existing nonessential

and excess insurance stock.

We further recommend that the Secretary of the Navy direct the

Commanding Officer, ASO, to set the retention level for insurance items at

one unit and change the disposal computer program so that the on-hand

stockage floor for these items also is one unit.

Agency Comments

and Our Evaluation

DOD generally agreed with the thrust of our recommendations but did not

agree with most of our report findings (see app. I). We have evaluated

DOD’s comments and continue to believe that our basic position is sound;

that is, the insurance inventories contain nonessential and excessive

stocks. Our comments on some of DOD’s specific statements are at the end

of appendix I.

Page 6 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

With regard to our recommendations, DOD stated that it would issue a

memorandum by June 30, 1995, (1) reemphasizing the need to review

insurance requirements prior to stock replenishment and (2) directing the

disposal of nonessential stocks. DOD also stated that the Navy will direct

ASO to reduce insurance stocks where the stockage is not in compliance

with DOD regulations.

The promised actions will be helpful, but they do not go far enough.

Because insurance items are not expected to fail, most will not be

reviewed if DOD only reviews those in need of stock replenishment. We

believe that DOD should review all insurance items periodically to identify

nonessential and excessive stocks. Over one half of the ASO insurance

items have been in the supply system more than 10 years, and 87 percent

have been in the supply system more than 5 years. Since then,

requirements may have changed due to DOD downsizing and weapon

system modification, obsolescence, or retirement. Unneeded insurance

stocks tie up warehouse space and increase managerial burdens.

Scope and

Methodology

To determine the adequacy of internal controls in the management of

insurance items, we reviewed DOD, Navy, and DLA procedures; interviewed

agency officials; and analyzed ASO and DISC computer files that contained

insurance item data as of March and April 1994. ASO files included the

master data file and disposal file. DISC files included the combined file

(similar to a master data file) and contract file.

By reviewing the files, we identified all insurance items managed by ASO

and DISC. We then analyzed these items to determine which were classified

as mission essential and which were stocked in quantities greater than one

unit. We did not assess the reliability of these files. However, to validate

insurance item data, we randomly sampled items that were not essential or

exceeded authorized stock levels. The sample included 329 items from ASO

files and 110 items from DISC files.

We sent a questionnaire to the ASO and DISC item managers responsible for

the sampled items. We asked the managers to validate and update the file

information, provide opinions on the essentiality of the items and causes

of excess stock buildups, and define the extent that excess stock was

disposable. Using this data from the ASO managers, we projected the

results to the universe from which the sample items were drawn at a

95-percent confidence interval. None of the DISC item managers had

responded to the questionnaire at the time our fieldwork was completed.

Page 7 GAO/NSIAD-95-1 DOD Insurance Stocks
B-258425 

We performed our review between February and September 1994 in

accordance with generally accepted government auditing standards.

The head of a federal agency is required by 31 U.S.C. 720 to submit a

written statement on actions taken on our recommendations to the Senate

Committee on Governmental Affairs and the House Committee on

Government Reform and Oversight not later than 60 days after the date of

the report. A written statement also must be sent to the Senate and House

Committees on Appropriations with the agency’s first request for

appropriations made more than 60 days after the date of the report.

We are sending copies of this report to the appropriate congressional

committees; the Director, Office of Management and Budget; the Secretary

of the Navy; and the Director, Defense Logistics Agency.

Please contact me at (202) 512-5140 if you have any questions. The major

contributors to this report are listed in appendix II.

Sincerely yours,

Mark E. Gebicke

Director, Military Operations

 and Capabilities Issues

Page 8 GAO/NSIAD-95-1 DOD Insurance Stocks
Page 9 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comments 1 to 4.

See comment 5.

See comment 6.

Page 10 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Page 11 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on p. 1.

Now on p. 2.

Page 12 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on pp. 2-3.

See comment 1.

Page 13 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

See comment 2.

See comment 3.

Page 14 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on pp. 3-4.

Page 15 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Page 16 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on pp. 4-5.

See comment 4.

Now on pp. 5-6.

See comment 5.

Page 17 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on p. 6.

Now on p. 6.

Page 18 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

Now on p. 6.

Page 19 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

The following are GAO’s comments on the Department of Defense’s (DOD)

letter dated November 28, 1994.

GAO Comments 1. The item mission essentiality codes we used in our analysis are

assigned to items to indicate their level of impact on the mission of

applicable equipment in the event stocks are depleted. The military

essentiality codes DOD said we should have used are assigned to indicate

the military importance of a part in relation to a higher component,

equipment, or weapon. Both sets of codes should provide the same

indication of mission essentiality and be based on input from technical

personnel. We analyzed the item mission essentiality codes because the

Aviation Supply Office’s (ASO) records showed these codes for 92 percent

of the insurance items. We could not analyze the military essentiality

codes because these codes were not shown on the records ASO provided us

for over 99 percent of the insurance items. After receiving our draft report,

DOD asked the Navy to determine the distribution of military essentiality

codes. This analysis showed that 58 percent of the ASO insurance items

were assigned a mission essential code, less than 1 percent were assigned

a not mission essential code, and the remaining 41 percent were blank and

not assigned a code. The Navy agreed that insurance items that are not

coded as mission essential must be validated.

2. Although engineers may make essentiality determinations, we opted to

send the questionnaire to the managers that have overall responsibility for

the items. In making this decision, we consulted with ASO officials and

asked them to review the questionnaire. We made their suggested changes

and pretested the questionnaire with item managers before it was

finalized. At no time in the process did ASO officials indicate that the

questionnaire should be sent to engineers rather than item managers.

Furthermore, we did not ask the item managers to refrain from consulting

with engineers, equipment specialists, end users, or others with greater

technical knowledge in preparing the responses. In fact, the responses

indicated that such consultations did take place in some cases.

3. We did receive responses to our questionnaire. In July 1994 we asked

the Defense Industrial Supply Center (DISC) to complete the questionnaire

for 110 insurance items, but DISC did not respond to the request by the time

our fieldwork was completed. However, in October 1994, after receiving

our draft report, the Defense Logistics Agency (DLA) provided responses

for 64 of the 110 items managed by DISC. The responses indicated that

14 percent of the insurance items were mission essential, 43 percent were

Page 20 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix I 

Comments From the Department of Defense

not mission essential, and the item managers did not know if the items

were mission essential for the remaining 43 percent. Also, the responses

indicated that 57 percent of the insurance items were stocked in quantities

that exceeded the authorized level of one unit.

4. At least two sections of the cited regulation state that one unit of an

item may be stocked for insurance purposes. For example, page 3-3 states

that essential items with no forecast of failure may be stocked as

insurance items in quantities not to exceed one replacement unit.

5. We have modified the report to address DOD’s comments on holding

costs.

6. At the completion of our fieldwork, we furnished ASO and DISC with

written summaries of our findings and potential recommendations. We

held an exit conference with ASO officials and gave them the opportunity to

comment on the summary. We gave DISC officials the same opportunity,

but they did not provide any comments. All of these actions were taken

before the draft report was submitted to DOD for formal review and

comment. In addition, prior to the ASO exit conference and the DISC exit

conference offer, we had numerous discussions with ASO and DISC officials

during the course of the review.

Page 21 GAO/NSIAD-95-1 DOD Insurance Stocks
Appendix II 

Major Contributors to This Report

National Security and

International Affairs

Division, Washington,

D.C.

James Murphy, Assistant Director

Philadelphia Regional

Office

Edward Rotz, Regional Management Representative

David Pasquarello, Evaluator-in-Charge

James Kurtz, Evaluator

Wayne Turowski, Computer Specialist

(703037) Page 22 GAO/NSIAD-95-1 DOD Insurance Stocks
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