United States General Accounting Office

GAO Report to Congressional Requesters

May 1995 OVERHEAD COSTS

Defense Industry

Initiatives to Control

Overhead Rates

GAO/NSIAD-95-115

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-260357 

May 3, 1995

The Honorable Floyd D. Spence

Chairman

The Honorable Ronald V. Dellums

Ranking Minority Member

Committee on National Security

House of Representatives

The Honorable James V. Hansen

The Honorable Norman Sisisky

House of Representatives

Senior Department of Defense (DOD) officials have expressed concern that

contractor overhead rates may drive up procurement costs as a result of

declines in DOD spending. In accordance with a September 26, 1994,

request from the former Chairman and Ranking Minority Member, we

reviewed (1) initiatives taken by six individual business units of large

defense contractors to reduce overhead costs and (2) the issue of whether

the units’ actions would avoid increases in overhead rates.

We selected business units of General Dynamics, General Motors,

Lockheed, Martin Marietta, McDonnell Douglas, and United Technologies.

The six units we visited were primarily engaged in defense work, and their

sales comprised an important part of the parent corporations’ total

government sales.1

 To protect proprietary data, we have not identified the

six business units we visited. Also, we frequently interchanged the

business unit labels (A-F) throughout the report to further ensure the

protection of proprietary data. While not projectable to the defense

industry, the six units’ actions provide some insight into measures taken to

control overhead rates.

Background DOD has estimated that overhead costs on average represent about

one-third of a contract’s price. However, these costs vary from contractor

to contractor and from industry to industry. Examples of costs that are

typically classified as overhead, because these costs are not directly

assignable to a specific contract but rather support a company’s total

business, include those of facilities and equipment, administrative and

general office support, computer operations, managers’ salaries, and

security. Overhead costs are generally accumulated by logical groupings

1

Includes sales made to foreign governments through the U. S. government.

Page 1 GAO/NSIAD-95-115 Overhead Costs
B-260357 

referred to as overhead cost pools. Manufacturing,2 engineering,3 and

general and administrative4

 overhead costs are commonly grouped in

separate cost pools. Contractors also commonly use separate pools for

material, tooling, selling, and off-site labor costs. Overhead rates are

computed by dividing the overhead cost pools by a common base such as

total direct labor dollars, total labor hours, or total costs. The overhead

rates are then used to allocate a company’s overhead costs to its contracts.

Because overhead costs are significant, senior DOD acquisition officials

have expressed concern that the sharp decline in defense spending would

lead to increases in contractor overhead rates and, in turn, increases in the

cost of individual defense programs. In February 1992, for example, the

Army’s Senior Acquisition Executive noted that declining defense budgets

would result in fewer programs and that, for most defense contractors,

this would mean a significantly smaller business base against which to

charge overhead. This condition, according to the executive, would drive

up contractors’ overhead rates and could result in increases or even

overruns in program costs.

In September 1992, the Secretary of the Air Force directed that overhead

should-cost reviews5

 be conducted at contractors responsible for the F-22

fighter aircraft program because overhead costs on that program had

increased by several hundred million dollars. In addition, a 1993 Defense

Science Board Task Force report recognized that the rapid loss of defense

sales would likely lead to significant increases in defense contractor

overhead rates. The task force noted that increases in overhead rates

could lead to unexpected and largely unavoidable cost increases in

existing programs, even if aggressive actions were taken to cut overhead

costs.6

Results in Brief Declining defense spending since the late 1980s has resulted in reduced

sales by defense contractors and a concurrent reduction in the business

bases against which they charge overhead. At the six business units we

2

Manufacturing overhead embodies all items of production cost, except direct materials, direct labor,

and other direct costs.

3

Engineering overhead includes the cost of directing and supporting an engineering department’s

activities.

4

General and administrative overhead includes the expenses of a company’s general and executive

offices; the costs of such staff services as legal, accounting, public relations, financial, and similar

functions; and the cost of other miscellaneous activities related to the overall business.

5

These reviews are a special form of a cost analysis that is used to evaluate the economy and efficiency

of a contractor’s overhead operations.

6

FY 1994-99 Future Years Defense Plan, Defense Science Board Task Force (May 1993).

Page 2 GAO/NSIAD-95-115 Overhead Costs
B-260357 

visited, for instance, sales declined by an average of 39 percent between

the peak years and 1993 and were projected to fall by an average of

55 percent between the peak years and latest projected years. However, in

response to their declining business bases, the business units had taken

action to reduce their overhead costs. Specifically, the six units reduced

their overhead costs by an average of 35 percent between their peak years

and 1993 and were anticipating on average a total reduction of 53 percent

between their peak years and latest projected years. To reduce overhead

costs, the business units had taken measures such as reducing the number

of indirect employees,7

 cutting employee health care benefits,

consolidating facilities, and reducing independent research and

development and bid and proposal (IR&D/B&P8

 expenditures.

Despite these efforts, overhead costs at four of the six business units were

not declining as rapidly as their sales; thus, these units were forecasting

increases in their overhead rates. One unit, for example, was projecting

the overhead rate to increase by 17 percent in real terms between 1993 and

2001. This means the business unit charged $1.50 in overhead costs for

every one dollar in direct labor in 1993, but will charge $1.76 in overhead

costs for every one dollar in direct labor by 2001. Unless these four

business units can identify additional cost reductions or increase their

sales, their overhead rates will continue to rise—a condition that could

result in increased procurement costs.

Defense Spending Is

Declining

The decline in defense spending since the late 1980s has eroded the

business bases against which contractors charge overhead. Total DOD

outlays,9 or expenditures, have fallen from a high of $354.110 billion in

fiscal year 1989 to $274.5 billion in fiscal year 1994—a $79.6-billion

decrease. The executive branch is projecting an additional decrease of

$50.0 billion in defense expenditures by fiscal year 2000. This would

represent a total decrease of $129.6 billion, or about 37 percent, between

fiscal years 1989 and 2000.

7

Employees are referred to as “indirect employees” when their work cannot be identified with a

specific cost objective but rather supports several cost objectives. The cost of indirect employees is

therefore charged to overhead accounts and allocated to all contracts.

8

IR&D is research and development initiated and conducted by contractors but is not specified under

any contract or grant. It is funded and managed at the contractor’s discretion from contractor

controlled resources, with a portion of the costs later recovered through overhead. B&P expenditures

are costs incurred in preparing, submitting, and supporting bids and proposals (solicited and

unsolicited) on potential government or nongovernment contracts.

9

DOD outlays generally represent cash payments and in a given fiscal year may represent the

liquidation of obligations incurred over a number of years.

10DOD outlays are stated in constant year 1995 dollars.

Page 3 GAO/NSIAD-95-115 Overhead Costs
B-260357 

More important to defense contractors, however, is that outlays for the

procurement account have fallen even more sharply than total outlays. As

shown in figure 1, procurement outlays are projected to decline from a

peak of $104.911 billion in fiscal year 1987 to $44.4 billion by fiscal year

2000—a reduction of about 58 percent. The procurement account is

important to defense contractors because it is the funding source for the

products they sell—weapons and components, communication and

support equipment, munitions, and other related items.

Figure 1: DOD Procurement Outlays

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

0

20

40

60

80

100

120

Fiscal year

Dollars in billions

Notes: Constant year 1995 dollars.

Figures for fiscal years 1995-2000 are executive branch projections.

11DOD’s procurement outlays are stated in constant year 1995 dollars.

Page 4 GAO/NSIAD-95-115 Overhead Costs
B-260357 

Since 1991, DOD has canceled, terminated, or reduced the production of a

large number of existing and planned weapons. According to a 1993

report,12 defense contractors are increasingly experiencing the impact of

these actions. The six business units we visited were particularly sensitive

to changes in defense spending because U.S. government sales13

accounted for an average of 94 percent of their total 1993 sales. As a result,

the reduction in defense spending has significantly eroded their business

bases. As shown in table 1, sales at the six business units we visited had

declined by an average of 39 percent between the peak year14 and 1993.

Moreover, the units were projecting their sales to decrease by an average

of 55 percent between the peak year and the latest year for which they had

made sales projections at the time of our visits—from 1997 to 2001

depending on the unit.

Table 1: Actual and Projected Declines

in Sales Based on Constant Year 1995

Dollars

In percent

Business unit Peak year through 1993

Peak year through last

projected year

A 29 62

B 36 50

C 54 51

D 42 55

E 48 62

F 21 73

Weighted average 39 55

Significant Reductions

Made in Total

Overhead Costs

The six business units we visited had significantly reduced their actual and

projected overhead costs. Some of the reduction can be attributed to

declines in the units’ business bases. However, the business units have

taken aggressive steps to reduce overhead costs to remain competitive in

an environment of declining sales. As shown in table 2, the six units have

reduced their overhead costs by an average of 35 percent between the

12Adjusting to the Drawdown: The Transition in the Defense Industry, Defense Budget Project

(April 1993).

13Includes sales made to foreign governments through the U.S. government.

14Peak sales years for the six business units varied from 1985 to 1989.

Page 5 GAO/NSIAD-95-115 Overhead Costs
B-260357 

peak year15 and 1993. They plan to reduce overhead costs by an average of

53 percent between the peak year and the latest projected year.16

Table 2: Actual and Projected

Reductions in Overhead Based on

Constant Year 1995 Dollars

In percent

Business unit Peak year through 1993

Peak year through last

projected year

A 25 32

B 40 62

C 63 69

D 41 53

E 11 67

F 30 39

Weighted average 35 53

Overhead Cost

Reduction Initiatives

Implemented

To reduce overhead costs, the business units targeted top overhead cost

drivers such as indirect labor, fringe benefits, and facilities and assessed

other areas of their overhead operations to identify additional cost

reduction opportunities. The cost reduction measures initiated by both the

business units and their corporate headquarters, which are shown in 

table 3, resulted in significant reductions in overhead costs. The initiatives

are discussed in greater detail in appendix I.

Table 3: Areas of Cost Reduction

Initiatives Business unit

Initiative ABCDEF

Indirect labor X X X X X X

Fringe benefits X X X X X X

Facilities X X X X X

IR&D/B&P expenditures X X X X X X

Employee compensation X X X X X X

Data processing costs X X X X X

Employee savings plans X X X X

Property taxes X X

According to information collected by the Defense Contract Management

Command (DCMC), the DOD organization primarily responsible for

overseeing contractor overhead costs, similar cost reduction initiatives are

15Peak overhead years varied from 1985 to 1989.

16Projected overhead costs are presented for the latest year forecasted by the business units at the

time of our visits—from 1995 to 2001.

Page 6 GAO/NSIAD-95-115 Overhead Costs
B-260357 

being pursued by major contractors throughout the defense industry.

Some of these initiatives have resulted in significant overhead cost

reductions. One of the business units we visited, for example, expects to

avoid more than $1 billion in costs from 1989 through 1996 by reducing

indirect personnel by laying off employees, contracting out at lower rates,

using part-time security guards, training salaried employees after hours,

and reducing duplicate functions (see fig. 2).

Figure 2: Indirect Labor Cost

Reduction in One Business Unit

$1 billion

cost avoidance

Proactive 

approach

"Do nothing" approach

1989 1990 1991 1992 1993 1994 1995 1996

250

300

500

400

450

500

550

600

650

Dollars in millions

Overhead Rates

Continue to Rise

Despite Cost

Reductions

Even though the business units we visited had taken measures to reduce

their overhead costs, these costs were not declining as rapidly as the

business bases at four of the business units. As a result, these units were

projecting increases in their overhead rates. To assess the significance of

these projections, we computed composite17 overhead rates from 1993 to

the last year forecasted.18 Business unit officials generally agreed that our

17The composite rates were computed by dividing total overhead costs by either a direct labor base or

a total cost base, with concurrence from unit officials.

18The last year of overhead rates forecasted by the business units at the time of our visits varied from

1995 to 2001.

Page 7 GAO/NSIAD-95-115 Overhead Costs
B-260357 

composite rates reflected the overall trend in their individual overhead

rates and provided a useful evaluation tool. As shown in table 4, four

business units will experience increases in their overhead rates from 1993

as the base year. Two of these increases are substantial.

Table 4: Percentage of Change in

Composite Overhead Rates Business unit 1993 through last projected year

A 9-percent increase

B 16-percent increase

C 17-percent increase

D 4-percent decrease

E 6-percent increase

F 7-percent decrease

Because overhead rates are used to allocate a company’s overhead costs

to government contracts, increases in these rates could cause the cost of

individual defense programs to increase, a concern shared by senior DOD

officials. The Secretary of Defense, for example, has pointed out that as

orders for defense systems decrease, defense contractors must decrease

their overhead because failure to do so could result in prohibitive

increases in unit costs, severely hampering DOD’s ability to modernize.

Scope and

Methodology

At the six business units we visited, we obtained information on actual and

forecasted business bases, total overhead costs, and overhead cost

reduction initiatives. To assess the impact of the cost reduction initiatives

on overhead rates, we analyzed trends in the business units’ engineering,

manufacturing, and general and administrative overhead rates. We also

computed composite overhead rates to assess the overall trends in

projected overhead rates and the potential cost impact on DOD contracts.

We discussed the business units’ cost reduction initiatives and projected

overhead rates with unit officials, as well as with DOD contract

administration and contract audit representatives at each of the units. In

addition, we examined various reports, papers, and other documents on

contractor overhead costs and rates throughout the industry. We did not

obtain DOD comments on the report; however, we discussed the results of

our review with business unit officials and incorporated their comments

as appropriate. We performed our review from March 1994 to January 1995

in accordance with generally accepted government auditing standards.

Page 8 GAO/NSIAD-95-115 Overhead Costs
B-260357 

We are sending copies of this report to the Secretary of Defense, officials

at the six business units we visited, and other interested congressional

committees. Copies of this report will also be made available to others

upon request.

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

concerning this report. The major contributors to this report were John K.

Harper, George C. Burdette, Anne-Marie Olson, and Amy S. Parrish.

David E. Cooper,

Director, Acquisition Policy, Technology,

 and Competitiveness Issues.

Page 9 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

The six business units we visited have taken initiatives to reduce overhead

costs in the environment of declining defense business. These initiatives

have resulted in significant reductions in overhead costs. Overhead costs

such as indirect labor, fringe benefits, and facility costs were considered

top overhead cost drivers, and we found that the six business units we

visited were taking measures to reduce these costs. Besides focusing on

their primary overhead cost drivers, the business units were also reducing

other overhead costs. Based on information the Defense Contract

Management Command (DCMC) had collected, the cost reduction initiatives

by these six units generally appeared to be representative of the kind of

actions being taken by major defense contractors throughout the industry.

Reduction in Number

of Indirect Personnel

Each of the business units we visited have significantly reduced the

number of indirect personnel as part of their cost reduction initiatives. As

shown in figure I.1, five1

 of the business units achieved reductions in

indirect personnel ranging from 43 percent to 77 percent between their

peak year employment2

 and 1993. In addition, the units were projecting

total reductions ranging from 51 percent to 82 percent from peak

employment years to the latest projected year.3

1

One of the six business units had records that did not contain a readily available breakout of direct

and indirect employees.

2

Peak indirect employment years varied from 1981 to 1987.

3

The latest projected years for indirect employment varied from 1996 to 2001.

Page 10 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

Figure I.1: Actual and Projected

Reductions in Indirect Personnel

ABCDE

0

20

40

60

80

100

77

66

43

62

43

82 81 80

64

51

Business unit

Peak to 1993 Peak to last projected year

In percent

Such reductions resulted in significant overhead cost savings because

indirect labor was a top cost driver at five of the business units we visited.

One unit, for instance, estimated it had saved $40 million in salaries and

fringe benefit costs by reducing indirect personnel by approximately

600 over a 2-year period.

Major personnel reductions have also occurred throughout the defense

industry. According to a DCMC assessment that included 20 contractors,

contractors have made significant reductions in their direct and indirect

employees since 1990. DCMC data showed, for example, that two major

defense contractors expected to save almost $1 billion in salary and fringe

benefit costs from 1991 through 1994 as a result of reducing the number of

their employees.

Page 11 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

Change in Employee

Fringe Benefits

At the six business units we visited, fringe benefits, particularly health

care costs, were also among the top overhead costs drivers. To reduce

health care costs, the business units increased employee deductibles,

raised co-payments, used preferred provider networks and health

maintenance organizations, and implemented flexible benefit programs.

DCMC data showed that other major defense contractors were taking

similar actions in the health care area.

Officials at one business unit we visited indicated that they expect to save

35 percent to 40 percent on health care costs (hospital and physician

services) by using preferred provider networks with agreed-to fee

schedules. This business unit also has shifted some of the health care

costs to its employees by increasing employee contributions by 50 percent.

In addition, this business unit has begun to promote early diagnosis and

prevention to avoid future costs. As shown by figure I.2, this business unit

expects to achieve a cost avoidance of over $3,000 per employee, or a total

of $79.9 million, between 1991 and 1996 as a result of its health care cost

reduction initiatives.

Page 12 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

Figure I.2: Reduction in Health Care

Costs Per Employee

$7,000 Cost without 

plan

modifications

Cost with 

plan

modifications

1991 1992 1993 1994 1995 1996 4,000

4,500

5,000

5,500

6,000

6,500

$3,000 reduction

Another business unit we visited reduced its workers’ compensation costs

by about $28 million through special work assignments, pharmaceutical

discounts, and a medical utilization program to assure appropriate

treatment is rendered. The DCMC data showed that other major defense

contractors were also taking action to reduce workers’ compensation

costs.

Consolidation of

Facilities

Facility costs were another top overhead cost driver. Five of the six

business units visited had reduced their total square footage by as much as

34 percent between their peak year4

 and 1993 by disposing of both owned

and leased space. In addition, the units were projecting reductions in their

total square footage ranging from 6 percent to 43 percent between the

4

Peak years for square footage varied from 1985 to 1991.

Page 13 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

peak year and latest projected year.5 The data collected by DCMC showed

that other major defense contractors were also reducing and consolidating

their facilities. According to the DCMC data, one defense contractor has

saved $95 million since 1988 by reducing the amount of leased facilities in

high cost areas. Figure I.3 shows the results of the facility consolidation

efforts of one of the business units we visited.

Figure I.3: Consolidation of Owned and Leased Facilities

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

0

1,000

2,000

3,000

4,000

5,000

Square feet in thousands

Owned Leased

By reducing owned and leased square footage, the business units we

visited had also reduced facility-related costs such as cafeteria expenses,

security costs, maintenance costs, property taxes, insurance, rental costs,

electricity, fuel, water, and sewage. One unit estimated it would save about

$10 million a year between 1987 and 1996 by eliminating these type costs.

5

The latest year of projected square footage available at the time of our visits varied from 1997 to 2001.

Page 14 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

Reduction in

Independent Research

and Development and

Bid and Proposal

Expenditures

The business units we visited had made reductions in their independent

research and development and bid and proposal (IR&D/B&P) expenditures

ranging from 31 percent to 71 percent between their peak years6

 and 1993.

At the time of our visits, the units were projecting total reductions in

IR&D/B&P costs ranging from 41 percent to 84 percent between their peak

years and latest projected years.7

 Figure I.4 shows the business units’

actual and projected reductions in IR&D/B&P expenditures.

Figure I.4: Actual and Projected

Percentage Reduction in IR&D/B&P

Expenditures

ABCDEF

0

20

40

60

80

100

57

71

31

52

45 48

84

62 61 59

48

41

Business unit

Peak to 1993 Peak to last projected year

In percent

One business unit we visited indicated that its IR&D/B&P expenditure level

was consistent with the expected reduction in the future defense budget.

An official of the business unit advised us that the unit plans to assess the

6

Peak IR&D/B&P years varied from 1984 to 1988.

7

The latest projected years for IR&D/B&P expenditures varied from 1997 to 2001.

Page 15 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

level of research and development investment in relation to its other

overhead allocations on an annual basis. The official indicated that the

benefit from those research and development expenditures will be

weighed against the company’s overall rate structure and cost

competitiveness. Another business unit planned to increase its emphasis

on long-term technology development. According to a representative from

this unit, the reduction in forecasted IR&D/B&P expenditures is consistent

with the forecast of declining defense business.

Reduction in

Employee

Compensation

The six business units we visited had controlled salary and labor costs by

using lump sum payments instead of merit wage or salary increases or by

limiting salary and wage increases. This action eliminated the effect of

compounding on future wages and wage-related fringe benefits. As a

result, one business unit expected to save approximately $34.7 million

over a 9-year period. In addition to this action, another business unit

eliminated overtime premiums for salaried employees, which reduced

costs by $11.4 million from 1990 to 1993. DCMC found that other major

defense contractors were making changes to their employees’

compensation, including instituting salary and wage freezes, to reduce

costs.

Data Processing Cost

Reduction

Five of the six business units we visited had initiated measures to reduce

data processing costs, including transitioning to low-cost data processing

alternatives, consolidating mainframe computing capabilities, and

contracting out data processing operations. One business unit expected to

realize a savings of about $27 million over a 5-year period by consolidating

two of its mainframe data centers. According to data being collected by

DCMC, other defense contractors have taken similar actions to reduce data

processing costs.

Changes to Employee

Savings Plans

Four of the business units we visited had changed their employee savings

plans to reduce overhead costs. One business unit temporarily reduced

company matching contributions to the savings plan by 50 percent,

resulting in a savings of about $22 million. According to the DCMC data,

other top defense contractors were taking similar actions. The DCMC data

showed, for example, that one contractor funded the administrative costs

of its employee savings plan through employee contributions, which has

saved the contractor an estimated $3 million.

Page 16 GAO/NSIAD-95-115 Overhead Costs
Appendix I 

Overhead Cost Reduction Initiatives

Property Tax

Reduction

Two of the business units we visited had initiated cost reduction actions

with their local governments. One unit achieved a $1-million a year cost

reduction by demonstrating lower market values for its plant sites based

on marketability, building condition, and occupancy. The other unit hired

an outside consultant to assess its property because it believed the county

was overstating the property assessment value. At the time of our visit, the

unit was still pursuing the issue with the county.

Other Cost Reduction

Initiatives

The business units we visited have taken a number of other measures to

reduce their overhead costs. One unit, for instance, renegotiated its

janitorial contract to reduce the number of trash collections and cleanings

as part of its continual process of seeking new ways to cut overhead cost.

The cleaning services contractor was making fewer daily pickups of

sanitary waste and was focusing on removing time-sensitive trash, such as

wet or organic matter, which enabled the contractor to use its resources

more efficiently and not adhere to the rigid or daily schedules previously

used. The unit expected to save about $200,000 annually. According to

DCMC information, other major Department of Defense contractors were

targeting waste reduction as a means of cost containment.

Another cost reduction initiative was to contract out various aspects of the

units’ operations. One unit expected to save $5 million over a 5-year period

by contracting out its cafeteria operations. According to the DCMC data,

other major defense contractors have also contracted out parts of their

operations to reduce their overhead costs.

(705095) Page 17 GAO/NSIAD-95-115 Overhead Costs
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