United States General Accounting Office

GAO Report to Congressional Requesters

December 1994 DEFENSE BUDGET

Capital Asset Projects

Undergo Significant

Change Between

Approval and

Execution

GAO/NSIAD-95-20

GAO United States

General Accounting Office

Washington, D.C. 20548

National Security and

International Affairs Division

B-257625 

December 28, 1994

The Honorable Sam Nunn

Chairman

The Honorable Strom Thurmond

Ranking Minority Member

Committee on Armed Services

United States Senate

The Honorable Carl Levin

Chairman, Subcommittee on Oversight of

 Government Management

Committee on Governmental Affairs

United States Senate

The Honorable Ronald V. Dellums

Chairman

The Honorable Floyd D. Spence

Ranking Minority Member

Committee on Armed Services

House of Representatives

The Department of Defense (DOD) is responsible for informing the

Congress about its capital asset needs in an annual Defense Business

Operations Fund (DBOF) capital budget.1

 Capital assets include such things

as equipment, minor construction, and management information systems.

In fiscal year 1994, the DBOF capital budget totaled $1.8 billion.

Concerned about apparent discrepancies between the DBOF capital budget

and actual capital asset spending, the Chairman, Subcommittee on

Oversight of Government Management, Senate Committee on

Governmental Affairs, asked us to (1) determine if DOD carries out the

projects identified in the capital budget and (2) assess the effectiveness of

DOD’s capital budget preparation and review process. The House and

Senate Committees on Armed Services (in the Conference Report on the

fiscal year 1994 National Defense Authorization Act) also required us to

determine the extent that DOD carries out the DBOF capital budget.

1

In fiscal year 1992 DOD consolidated several stock and industrial revolving funds, plus other selected

business operations, into a single revolving fund called DBOF.

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Results in Brief DOD continues to experience significant problems in managing its capital

asset program and carrying out its capital budget. The activities we visited,

for example, canceled 86 percent and 65 percent of the projects in their

fiscal year 1993 and 1994 capital budgets, respectively. Our analysis of 

56 fiscal year 1994 projects at 6 defense activities showed that a large

number of cancellations occurred because of weaknesses in the budget

justification and preparation process. The uncertain environment caused

by base closings and realignments, budget reductions, and other DOD

management initiatives also contributed to project cancellations. Because

activity managers usually replaced the canceled projects with others, the

projects carried out by the six activities bear little resemblance to those in

the capital budget submitted to the Congress.

DOD has developed new guidance that, if properly implemented, will

strengthen the DBOF capital budgeting process. This guidance is a step in

the right direction but can be improved by requiring activities to

(1) closely link their capital investment decisions to long-range activity

plans and missions and (2) rely on net present value as the primary

investment decision criterion for rank ordering competing capital

investment projects.

Developing new procedures, however, is only a first step. These are

long-standing problems that have been reported many times by us, the

Inspectors General, and service audit agencies. High-level management

attention, training, and appropriate oversight mechanisms are necessary to

ensure that key managers fully understand and implement the new

guidance. One such mechanism is to include capital asset program

deficiencies in the Federal Managers’ Financial Integrity Act report. This

elevates the significance of the deficiencies and requires special

management oversight and tracking.

Background In fiscal year 1992, DOD consolidated nine industrial and stock funds into a

single revolving fund called DBOF.

2

 The establishment of DBOF did not

change any previous organizational reporting structure or command

authority relationship. DOD consolidated cash management activities,

which helped reduce the amount of cash needed to operate the funds, but

functional and cost management responsibilities for the industrial and

stock funds remained with the military departments and defense agencies.

2

DBOF activities also include the following defense agencies: Defense Finance and Accounting

Service, Defense Commissary Agency, Defense Technical Information Center, Defense Reutilization

and Marketing Service, and Defense Industrial Plant Equipment Center.

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Modeled after private sector business operations, DBOF industrial and

stock fund activities have a contractual (buyer-seller) relationship with

their customers, primarily other elements in the military departments and

defense agencies. These activities, for a fee, provide such services as the

overhaul of ships, tanks, and aircraft and sell over 5 million types of vital

inventory items, such as landing gears and other aircraft parts. Many of

these items are essential to maintaining the military readiness of weapon

systems and military personnel. Activities within DBOF have assets

reportedly valued at $126 billion and expect fiscal year 1995 revenue of

$77 billion, making them equivalent to one of the world’s largest

corporations.

When DBOF began in 1991, DOD reinstated a process where capital asset

investments costing more than $15,000 are purchased with revolving funds

rather than through direct appropriations. DOD funds these capital

investments by including depreciation expenses in the prices activities

charge their customers. If the amount of depreciation is not sufficient to

fully fund the investment program, DOD adds a surcharge to the price.

Table 1 identifies the capital budgets for fiscal years 1993 through 1995,

along with the amount of the surcharge added each year.

Table 1: Capital Asset Budget and

Depreciation Surcharges

Fiscal year

Capital asset budget

(billions)

Surcharge

(millions)

1993 $1.5 $40.9

1994 1.8 31.5

1995 1.44 446.3a

aDOD added the large fiscal year 1995 surcharge primarily to fund the Joint Logistics Systems

Center. DOD considers this center a DBOF capital investment because the bulk of its funding

goes directly to the development of DBOF-related financial and inventory management systems.

Although capital asset investments are financed through DBOF revolving

funds, DOD prepares and submits an annual DBOF capital budget to the

Congress, which identifies the projects each activity will undertake during

the fiscal year. All projects costing $500,000 or more must be shown as

separate line items and fully explained and justified. Items under $500,000,

such as forklifts, trucks, and trailers, must be equally justified but can be

combined as one budget line item for each business area.

The DBOF Policy and Responsibilities Statement issued on September 27,

1991, and service-level guidance require the services and defense agencies

to justify all projects included in the capital budget sent to the Congress.

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Among other things, budget developers must document the reasons for

planned capital investment purchases and their expected benefits. This

justification data should include the workload projections the purchase is

based on as well as the source or rationale supporting the projections. In

addition, the benefits of a capital project should be supported, depending

on its dollar value and purpose, by some type of cost or economic analysis.

The statement also requires that this justification data be retained and

readily available for review, audit, or evaluation.

Higher service and defense agency command levels review and

consolidate field activities’ projects into budget submissions. These

submissions are then sent to the DOD Comptroller for further review and

evaluation. The Comptroller, in turn, consolidates the budget submissions

into the capital budget, which is sent to the Congress.

Large Percentage of

Capital Projects Are

Canceled or

Postponed

The activities cited in tables 2 and 3 canceled or postponed 86 and 

65 percent of the projects they included in the fiscal years 1993 and 1994

capital budgets, respectively. The value of these projects was $40.3 million

in fiscal year 1993 (57 percent of the activities’ total capital budgets) and

$35.5 million in fiscal year 1994 (47 percent). Although the rate of

cancellations and postponements varied, the Army activities, by far, were

the least successful in carrying out their capital budgets. Tables 2 and 3

summarize the status of the fiscal years 1993 and 1994 capital budgets for

the activities we visited.

Table 2: Fiscal Year 1993 Cancellations

and Postponements

Projects in

President’s 1993

budget

Projects canceled or

postponed

Percent canceled or

postponed

Dollars in millions

Activities visited Value Number Value Number Value Number

Army depot

maintenance

activitya $41.2 246 $28.5 225 69 91

Two Air Force

activities 16.4 44 3.8 33 23 75

Two Navy

activities 12.8 64 8.0 46 63 72

Total $70.4 354 $40.3 304 57 86

aAlthough we visited two Army maintenance depots at Letterkenny, and Tobyhanna,

Pennsylvania, we obtained statistics for all Army maintenance depots.

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Table 3: Fiscal Year 1994 Cancellations

and Postponements

Projects in

President’s 1994

Budget

Projects canceled or

postponed

Percent canceled or

postponed

Dollars in millions

Activities visited Value Number Value Number Value Number

Army depot

maintenance

activitya $35.7 109 $23.3 91 65 84

Two Air Force

activities 25.5 82 6.4 39 25 48

Two Navy

activities 14.0 42 5.8 22 41 52

Total $75.2 233 $35.5 152 47 65

aAs in table 2, the data includes projects for all Army maintenance depots, not just the two we

visited at Letterkenny, and Tobyhanna, Pennsylvania.

When a project was canceled or postponed, officials at the six activities

we visited told us they usually substituted it with another project. The Air

Force Materiel Command, for example, has given the San Antonio Air

Logistics Center reprogramming authority for any project under $500,000.

Thus, when the DBOF capital budget is approved and funding levels are

established for San Antonio, the local commander has the discretion to

use that money for any capital project, not just those in the capital budget.

In the fiscal year 1994 capital budget for the San Antonio Air Logistics

Center, 77 of the 82 projects were less than $500,000.

Even though the Air Force Systems Command directed the San Antonio

Air Logistics Center to keep documentation showing why projects are

canceled, local managers at the Center were not clear about these

requirements. As a result, some files for canceled projects had been

discarded and others were missing justification documents. Therefore, in

many cases, we were unable to determine why a project was canceled or

postponed.

The Navy activities we visited had similar authority to cancel and

substitute capital projects under $500,000. The Army activities, on the

other hand, needed approval to cancel a project and substitute it with

another. This approval, however, was not hard to obtain, as evidenced by

the large percentage of canceled projects at the Army maintenance depots.

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DOD officials acknowledged that DBOF activities have not always executed

the capital asset program as planned. To address this problem, DOD

specifically listed the capital asset projects authorized for execution in the

fiscal year 1994 annual operating budgets that were issued to the DBOF

activities. The services and DOD components must report any deviation

from the approved capital asset program to the DOD Comptroller’s Office.

This initiative could help improve program execution.

Poor Justification

Process and Other

Factors Caused

Cancellations and

Postponements

To determine why such a large percentage of projects are canceled or

postponed, we interviewed managers at various levels of the capital

budget preparation and review process. We also judgmentally selected and

reviewed, in detail, 56 fiscal year 1994 budgeted projects for the 6 activities

we visited. Based on this work, most cancellations and postponements

seem to be occurring because DOD has not corrected the capital budgeting

problems that existed before DBOF was created in 1991. In addition, Base

Realignment and Closure decisions and other budget uncertainties have

created an environment that contributed to capital projects being canceled

and postponed.

Weaknesses in the Budget

Justification Process Have

Not Been Corrected

DOD’s industrial activities used revolving funds to finance capital asset

purchases between fiscal years 1983 and 1989 under what was known as

the Asset Capitalization Program. In fiscal year 1990, the Congress

terminated this program and began funding capital equipment purchases

through the procurement appropriation. This change, which lasted 2 fiscal

years, was aimed at giving the Congress greater visibility over capital

equipment purchases. It was necessary because of significant

implementation problems service audit agencies, inspector generals, and

we repeatedly identified between 1986 and 1990.

Before DBOF was implemented, we reported3

 that DOD had not made the

necessary changes to its capital equipment program. At that time, we

concluded that the adoption of DOD’s proposal to fund capital equipment

through DBOF, prior to correcting the previously reported weaknesses,

could continue the abuses and poor management practices we found with

the Asset Capitalization Program. As described below, many of the

previously described weaknesses have continued under DBOF.

3

Industrial Funds: Weaknesses Remain in the Department of Defense’s Capital Equipment Program

(GAO/NSIAD-91-175, Apr. 17, 1991).

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B-257625 

Capital Purchases Are Not

Based on Long-Range Strategic

Plans

One of the major implementation problems with the Asset Capitalization

Program was that the industrial fund activities lacked a systematic

approach to identifying capital investment opportunities. Although each of

the activities was required to prepare long-range (3 to 7 years) strategic

plans that identified facility and equipment requirements, these plans were

not being used consistently to guide the activities’ current equipment

needs or to buy priority equipment. As a result, these activities had no

assurance that their most critical long-term needs were being met through

the Asset Capitalization Program.

A similar situation existed at the six activities we visited. Although DOD

relies on these activities to identify most of their capital equipment needs,

these needs were not linked in any systematic way to the activities’

long-range requirements and future missions. In fact, the activities were no

longer preparing long-range strategic plans. Several managers told us they

lacked the resources to keep long-range plans current, and the downsizing

environment reduced the emphasis on long-range planning. Officials at the

two Army activities we visited said that long-range plans are no longer

required.

Instead, the activities generally relied on local managers to identify and

rank capital investment needs. For example, the Naval Air Warfare Center

at Warminster, Pennsylvania, initially allows department heads to identify

capital projects. These are reviewed and prioritized by a management

board, approved by the Warminster Commanding Officer and other

officials, and subsequently reviewed by several additional layers in the

Navy and the DOD Comptroller.

However, (1) no documentation is prepared that links capital investment

projects to Warminster’s long-term or future requirements, (2) Warminster

officials canceled or postponed a large number of projects in the 1994

capital budget, and (3) higher level reviewers within the Navy seldom

question the projects selected by the field activities. They said the

activities and their commands were in the best position to know which

projects best suited their requirements. This environment, in our view,

does not provide the control necessary to ensure that the projects selected

are the ones that best match long-range requirements.

Capital Projects Are Not

Adequately Justified, Reviewed,

and Approved

Another major implementation problem with the Asset Capitalization

Program was that the industrial fund activities were not complying with

procedures for justifying and approving capital projects. By not following

these requirements, the activities had no assurance that capital resources

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B-257625 

were being used on the best projects. It also did not give them a baseline

to measure the financial benefits of the projects.

During our audit work, we found that not much had changed. The Army

activities, for example, were not performing any project analysis or

preparing justifications until the year of execution. That is, justification

documents for fiscal year 1993 projects were being prepared in fiscal year

1993, not in fiscal year 1991 when the budget was prepared. As a result, the

budget was little more than a listing of projects local managers believed

could be done within expected budget allocations. The Army Depot

System Command also included a $5.4-million “contingency” amount (for

which there were no specific projects) in the fiscal year 1994 capital

budget sent to the Congress.

The consequence of this process is that when the Army activities

performed an analysis, usually prior to or as part of the procurement

action, they found many projects were not high priority. For example, one

of Letterkenny’s 1994 projects was for a machine that punches holes in

various metal components and precuts reinforcement rods for concrete

applications. The existing machine was over 13 years old and beyond its

estimated life expectancy. For that reason, a project to replace the

machine was included in the budget, but when an analysis later showed

that the existing machine was in good shape, the project was canceled. At

the time of our review, the Army was aware of the deficiencies in its

capital budget justification process and was taking action to improve the

process, starting with the fiscal year 1994 capital budget.

Although the problems were not as systemic at the Air Force and the Navy

activities we visited, none were fully adhering to sound justification and

approval criteria for capital investments. A major part of the problem is

that DOD’s current capital investment guidance for DBOF activities does not

adequately describe how to justify a capital investment project. More

importantly, the services have not yet developed detailed implementing

policies and procedures for the field activities to follow. As a result, the

activities were using service-level and local guidance that was either

severely deficient or out of date. The Air Force, for example, was using

expired guidance from the old Asset Capitalization Program. This

guidance did not (1) reflect the major reorganization that had taken place

at the San Antonio Air Logistics Center, (2) assigned duties to management

positions that no longer existed, and (3) identified the capital asset

threshold as $5,000 rather than $15,000. Also, the Navy activities we visited

were using expired guidance and instructions from other Navy commands.

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This lack of policies and procedures was confirmed in a report issued in

July 1993 by the DBOF Implementation Review Group. This group,

chartered by the Secretary of Defense, concluded that documentation

requirements for capital investment decisions are not clearly defined and

managers do not understand the process. It recommended that the DOD

Comptroller clarify policy on techniques and procedures for investment

analysis. This group also issued a DBOF improvement plan in

September 1993 that tasked the DOD Comptroller to develop guidance on

the techniques and procedures for analysis and documentation of capital

projects. Implementation was anticipated for late 1994.

Program Benefits Are Not

Measured

An effective capital investment program contains a mechanism for

analyzing whether the projects meet the projected financial benefits and

for collecting data so that management can make better investment

decisions. This mechanism, called a post-investment analysis, was

generally not done under the old Asset Capitalization Program. As a result,

when we assessed this program in 1989, we concluded that DOD did know

what benefits the program had produced or if equipment purchased had

actually been used. This was important because we found many completed

projects that had not achieved anticipated results.

Current DBOF criteria requires a post-investment analysis for any capital

project that was justified wholly or partially on the basis of economic

considerations. During our visits, we did not look at completed projects to

determine whether they had achieved anticipated results, but we did find

that none of the activities were doing post-investment analyses. A San

Antonio Air Logistics Center official said, for example, that the Air Force

Materiel Command no longer required this type of analysis. The Navy, on

the other hand, had specific criteria for performing a post-investment

analysis. Unfortunately, activity managers at the Navy’s Lakehurst and

Warminster facilities said that they do not do these type of analyses. A

Warminster official cited resource constraints as the primary reason for

not performing a post-investment analysis.

Uncertain Environment

Places a High Premium on

Capital Investment

Planning

All the activities we visited were affected by military downsizings, base

closure and realignment decisions, and other DOD management initiatives.

Since 1991, for example, the Letterkenny Army Depot has been either

closed, downsized, realigned, or had its mission expanded because of the

Base Realignment and Closure process. Likewise, the Naval Air Warfare

Center at Warminster, Pennsylvania, will move to Patuxent River,

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B-257625 

Maryland, and become part of the Navy’s Aircraft Division as part of the

1991 Base Realignment and Closure recommendations.

Although the San Antonio Air Logistics Center was not directly affected by

closure and realignment decisions, all air logistics centers and DOD depots

are going through major changes that could affect their missions. In recent

testimony, we discussed such issues as depot closings, DOD efforts to

arrive at a proper mix of depot maintenance work between public and

private sectors, and the public-private competition initiative DOD is using to

allocate the depot maintenance workload.4

According to agency officials, these initiatives plus other workload shifts

(e.g., B-52 maintenance is moving from San Antonio to the Oklahoma City

Depot) has made their capital asset needs hard to predict. Considering that

the DBOF budget is prepared at the field level almost 18 months before the

fiscal year it will be executed in, these officials said they were not

surprised by the large number of cancellations and postponements.

However, in our review of the 56 projects, we were only able to tie 3 of the

36 cancellations and postponements specifically to the uncertainty of the

downsizing environment. A number of projects were canceled because of

“other higher priority requirements.” This was particularly true at the San

Antonio Air Logistics Center. Because this Center did not always keep

documentation associated with the cancellation decision, we were not

able to determine if the cancellations were linked to specific changes in

the Center’s business environment.

We understand the challenge DOD faces in trying to manage its capital

investment program during this period of uncertainty. At the same time,

we believe adequately justifying capital investment projects and linking

them to the long-range strategic plans for each activity is more important

than ever. Without the discipline associated with such a sound investment

planning process, funds can be wasted on either unneeded or low priority

projects.

Budget Presentation Does

Not Adequately Reflect

Project Changes

DOD’s capital budget includes projects for 3 fiscal years: the current year

under consideration and an update of the 2 prior years’ budgets. For

example, the fiscal year 1994 budget, which DOD submitted to the Congress

4

Depot Maintenance: Issues in Allocating Workload Between the Public and Private Sectors

(GAO/T-NSIAD-94-161, Apr. 12, 1994).

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in April 1993, included capital projects proposed for 1994 and an updated

list of 1992 and 1993 projects.

We found that it was difficult to track the changes that occurred between

the fiscal year 1993 budget and the 1993 update, primarily for two reasons.

First, most capital projects (those under $500,000) are summarized by

DBOF business area and identified by single line items in the budget.

Therefore, it is impossible for us or the Congress to determine which or

how many projects have been canceled without comparing detailed

backup information for the 2-year period. Second, DOD does not indicate in

the budget update what projects over $500,000 are replacements. The only

way to tell is to compare the update with the previous year’s budget,

which is a labor-intensive effort subject to error. For example, we noted

that three planned fiscal year 1993 projects over $500,000 were not in the

subsequent budget update and assumed they had been canceled. However,

a service official pointed out that they had not been canceled. As a result

of new cost estimates of less than $500,000, these projects were no longer

identifiable as separate budget line items. They were still in the budget but

as part of other budget categories.

DOD Has Developed

New Capital Asset

Justification Criteria

In response to the DBOF Implementation Review Group’s September 1993

recommendations, DOD has developed new guidance for justifying and

performing economic analyses for DBOF capital investment projects. This

guidance requires that all capital projects included in the DBOF capital

budget be supported by a sound analytical evaluation. Based on our

review of the guidance, we believe that it has the potential—if effectively

implemented—to address most of the problems we found with DOD’s

capital investment justification process.

The guidance requires DOD components to prepare a thorough economic

analysis for all DBOF projects over $100,000 at least 18 months before the

year of execution; certain environmental and equipment replacement

projects are exempt. In addition, it requires activities to prepare project

documentation that, among other things, describes the need for the

project, workload projections that support the requirement, feasible

alternatives considered, total project costs and savings expected over a

10-year period, estimating methods, and intangible benefits.

Similar requirements would apply to projects under $100,000, except that

the economic evaluation would be less than a complete economic analysis.

We believe these changes will help solve the budget justification

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deficiencies and require DBOF activities to include only its highest priority

projects in the capital budget.

We do have three concerns about the new guidance. First, it makes no

mention about the need to link capital projects to the long-range

investment needs of the DBOF activity. DOD officials said, and to a certain

extent we agree, that the strict justification requirements will reduce the

likelihood that any unneeded project could be supported. They also

pointed to new budget guidance that requires capital assets to meet

long-range planning and programming objectives. Nevertheless, any new

capital investment policy would be remiss if it did not require a direct link

between large capital investments and the long-range mission of the

installation. Long-range planning is even more important in an

environment of downsizing since activities need to maximize shrinking

resources.

Second, the new guidance advocates investment decision criteria that may

not produce the greatest net benefits. For projects less than $100,000, for

example, the draft guidance requires activities to use “payback” (the time

necessary for an alternative to repay its investment cost) as the primary

indicator to rank order projects. For projects equal to or over $100,000, the

“benefit-to-investment ratio” (total present value of benefits divided by

total present value of costs) is to be the primary indicator for ranking

projects. This is contrary to the Office of Management and Budget (OMB)

criteria,5

 a recent GAO report,6 and current economic literature that

advocates “net present value” as the appropriate criterion for choosing

among independent, competing investment projects. “Net present value” is

the difference between the present value of benefits and the present value

of total costs. It is favored over other indicators because it more

consistently results in the selection of projects with the greatest benefits,

net of cost. (See app. I for numerical examples.) Furthermore, DOD would

not need any additional information, beyond that necessary to calculate

payback and benefit-to-investment ratios, to calculate net present value.

Third, the new policy guidance will require a major adjustment in the way

activities select and justify capital projects—in effect a cultural change.

We believe such a change will not come about just by issuing a new policy

statement, particularly for such long-standing problems. In February 1992,

we reported that private companies use a combination of techniques to

5

U.S. Office of Management and Budget, Circular No. A-94 (revised Oct. 29, 1992).

6

Federal Budget: Choosing Public Investment Programs (GAO/AIMD-93-25, July 1993).

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B-257625 

successfully change their cultures.7 Two techniques most important to

success were (1) top management support and commitment to the effort

and (2) training of employees to instill in them the organization’s new

mission, values, and guiding principles. Other key techniques included

communicating the organization’s vision and goals to its employees and

creating a specific management style that reinforces this desired vision

and these goals. Unless DOD addresses these types of issues, we do not

believe the new policy will be any more successful than the out-of-date

and inadequate guidance that currently exists.

DOD Did Not Identify

Capital Asset Program

Deficiencies as a

Material Weakness

Under the Federal Managers’ Financial Integrity Act, the Secretary of

Defense is required to review DOD’s internal accounting and administrative

controls to provide reasonable assurances that funds, property, and other

assets are safeguarded against waste, loss, unauthorized use, or

misappropriation and that internal management controls emphasize

prevention and correction of specific problems. DOD has not identified the

capital asset program deficiencies we cite in our report as material

weaknesses requiring corrective action.

Recommendations We endorse the direction that DOD has taken to improve the capital

investment justification process. To build on those planned actions, we

recommend that the Secretary of Defense

• require that the new DBOF policy statement on capital budget investment

projects include requirements to (1) link capital investment projects to the

DBOF activities long-range plans and missions and (2) rely on net present

value as the primary investment decision criterion for rank ordering

competing capital investment projects;

• develop plans and schedules for training the key people responsible for

implementing the new guidance;

• develop mechanisms to track implementation of the new guidance and

hold managers accountable for achieving the intent of the guidance;

• include capital asset justification program deficiencies as a material

weakness in the Federal Managers’ Financial Integrity Act report; and

• identify, in its annual DBOF capital budget update, (1) projects canceled or

postponed since submission of the last budget and (2) projects selected as

replacements for those canceled or postponed.

7

Organization Culture: Techniques Companies Use to Perpetuate or Change Beliefs and Values

(GAO/NSIAD-92-105, Feb. 27, 1992).

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Agency Comments

and Our Evaluation

DOD reviewed a draft of this report and provided written comments. In

summary, DOD agreed that there was an overall need to improve its policies

governing the management of the DBOF capital asset program and that it

had recently made such changes, which it said were consistent with

improvements suggested in this report. (See app. II.) It disagreed,

however, with our recommendations to use net present value as the

primary investment decision criterion for choosing among competing

investment projects and to cite capital asset justification deficiencies in

the Federal Managers’ Financial Integrity Act report.

DOD offers no specific reason it has not adopted net present value as the

primary criterion for choosing among competing investment projects.

DOD’s comments refer to its new DBOF policy statement that it believes

allows managers to consider net present value along with other economic

indicators. While the policy statement does require DBOF managers to

calculate net present value for each investment project, it says they should

use either payback or benefit-to-investment ratio as the primary criterion

for ranking projects. As we discuss earlier, this is inconsistent with OMB

economic criteria and could cause managers to select projects that will

not produce the greatest net benefits. (See app. I.)

DOD also said that the capital asset program deficiencies we identified are

not sufficient to require inclusion under the Federal Managers’ Financial

Integrity Act and that its new policy changes are expected to achieve the

desired improvements and internal controls. We disagree. The problems

with DOD’s capital investment program are long-standing and have been

reported many times by us, the Inspectors General, and service audit

agencies over the past 6 years. Although the new policy statement is a step

in the right direction, we believe DOD needs high-level management

oversight and attention to achieve effective implementation. Listing the

program as a material weakness in the Federal Managers’ Financial

Integrity Act report provides an added level of management attention.

Further, during the fiscal year 1995 defense authorization process, the

Senate and House Committees on Armed Services considered the

problems in this area serious enough to reduce the money available for

capital asset purchases by $160 million (from $1.6 billion spending

authority requested by DOD to $1.44 billion). This emphasizes the need for

DOD to address this issue as a material weakness and ensure that

improvements are effectively implemented. Additional DOD comments and

our responses appear in appendix II.

Page 14 GAO/NSIAD-95-20 Defense Budget
B-257625 

We performed our audit work between December 1992 and June 1994 in

accordance with generally accepted government auditing standards. (See

app. III for details on our scope and methodology.) We will also be sending

copies to the Chairmen, Senate Committee on Governmental Affairs,

House Committee on Government Operations, and Senate and House

Committees on Appropriations; the Director, Office of Management and

Budget; the Secretaries of Defense, the Army, the Navy, and the Air Force;

and other interested parties. We will make copies available to others on

request.

If you have any additional questions, please contact me on (202) 512-8412.

Major contributors to this report are listed in appendix IV.

Donna M. Heivilin, Director

Defense Management and

 NASA Issues

Page 15 GAO/NSIAD-95-20 Defense Budget
Contents

Letter 1

Appendix I 

Basis for Using Net

Present Value

18

Appendix II 

Comments From the

Department of

Defense

20

Appendix III 

Scope and

Methodology

38

Appendix IV 

Major Contributors to

This Report

40

Tables Table 1: Capital Asset Budget and Depreciation Surcharges 3

Table 2: Fiscal Year 1993 Cancellations and Postponements 4

Table 3: Fiscal Year 1994 Cancellations and Postponements 5

Table I.1: Comparison Based on Payback Period 18

Table I.2: Comparison Based on Benefit-to-Cost Ratio 19

Table III.1: DOD Organizations Visited 38

Abbreviations

DBOF Defense Business Operations Fund

DOD Department of Defense

OMB Office of Management and Budget

OSD Office of the Secretary of Defense

Page 16 GAO/NSIAD-95-20 Defense Budget
Page 17 GAO/NSIAD-95-20 Defense Budget
Appendix I 

Basis for Using Net Present Value

The new policy guidance states that the primary criterion used for

evaluating alternative investments should depend on the cost of the

project. For projects under $100,000, the guidance requires the minimum

payback period; for those $100,000 or more, it requires the maximum ratio

of benefit to investment cost. This appendix presents some simple

numerical examples to demonstrate that it is possible for either of these

two criteria to signal the selection of one or more projects that differ from

the selection signaled by the maximum net present value criterion.1

The minimum payback period criterion calls for selection of the project

that recovers its investment cost in the shortest period of time. Table I.1

shows a comparison of two competing, mutually exclusive projects.

Table I.1: Comparison Based on

Payback Period

Project Initial cost (C0)

First year net

benefits (B1 - C1)

Second year net

benefits (B2 - C2)

A 100 110 1

B 100 0 1000

Both projects require an initial outlay of $100, the total budget available

for investment, and both last 2 years. The cost of project A is recouped

during the first year, while cost recoupment for project B does not occur

until the second year. According to the minimum payback period criterion,

therefore, A should be the project chosen. However, considering the size

of the second year payoffs ($1,000) relative to those of the first year

($110), the minimum payback period judgment is clearly faulty.

The maximum benefit-to-cost ratio (B/C) criterion can signal the wrong

selection of projects. Once again, consider two competing, mutually

exclusive projects, A and B, only one of which can, due to a limited

budget, be selected. The life span of each project is 1 year. Suppose that

the interest rate appropriate for discounting purposes is 5 percent. 

Table I.2 compares these projects.

1

All of these examples are taken from Peter G. Sassone and William A. Schaffer, Cost-Benefit Analysis:

A Handbook (New York: Academic Press, 1978), pp. 15 and 19-21.

Page 18 GAO/NSIAD-95-20 Defense Budget
Appendix I 

Basis for Using Net Present Value

Table I.2: Comparison Based on

Benefit-to-Cost Ratio Initial period Next period

Project (B0) (C0) (B1) (C1) B/C NPVa

A 0 1 2 0 1.9 0.9

B 0 5 8 0 1.5 2.6

aNet present value.

According to the maximum benefit-to-cost ratio criterion, project A should

be chosen because its B/C, 1.9, exceeds that of project B, 1.5. Yet a

comparison of total benefits net of costs clearly indicates that project B is

preferable because project B’s net benefit, $2.60, exceeds that of project A,

$0.90.

Both of the preceding examples tacitly assume that only two projects are

candidates for selection. Situations can arise, of course, when two or more

projects can be selected, subject to a budget constraint. In such a

situation, ranking projects by their benefit-to-cost ratios and choosing

successively lower ranked projects (beginning with the project having the

largest benefit-to-cost ratio) will maximize total net present value.

Page 19 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

Page 20 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Page 21 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on pp. 3 and 4.

Page 22 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

See comment 1.

Page 23 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on pp. 5 and 6.

See comment 2.

Page 24 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on p. 6.

See comment 3.

Now on p. 7.

Page 25 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

See comment 4.

Page 26 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on pp. 7-9.

See comment 5.

See comment 6.

Page 27 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on p. 9.

See comment 7.

Now on pp. 9 and 10.

Page 28 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on pp. 10 and 11.

See comment 8.

Page 29 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on pp. 11-13.

See comment 4.

Page 30 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

See comment 7.

See comment 6.

See comment 9.

See comments

on p. 14.

Page 31 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on p. 13.

See comments

on p. 14.

Now on p. 13.

See comment 4.

See comment 7.

Page 32 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

See comment

on p. 14.

Now on p. 13.

See comment 9.

Now on p. 13.

See comment 10.

Now on p. 13.

See comments

on p. 14.

Page 33 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

Now on p. 13.

See comment 8.

Page 34 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

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

letter dated September 16, 1994.

GAO Comments 1. Here and several other times throughout the comments, DOD states that

the problems with the capital asset budgeting process have been resolved.

As we state in the report, however, the Defense Business Operations Fund

(DBOF) entities we reviewed were not following existing guidance and not

much was being done at higher levels to ensure that the capital asset

justification criteria were being followed. Although the new guidance adds

specificity to the requirements for acquiring a capital asset, the key issue is

effective implementation. That is why we included recommendations for

DOD to train its key managers on how to implement the new guidance,

develop performance measures to track implementation, hold managers

accountable for achieving the intent of the guidance, and include capital

equipment program deficiencies in its Federal Managers’ Financial

Integrity Act report.

2. We found no evidence that capital asset projects were being

systematically assessed against this type of criteria. To the contrary, we

saw a rather loose capital asset justification process that did not match the

criteria to which DOD refers. DOD’s DBOF Implementation Review Group

found similar circumstances and recommended that the DOD Comptroller

develop guidance for analyzing and documenting its capital investment

decisions.

3. DOD’s comment is out of context. At this point in the report, we are

describing the results of our work as it relates to findings in past reports

by us, defense Inspectors General, and service audit agencies. In that

context, we found that DOD had not corrected previously identified

problems. We recognize later in the report that DOD has developed new

policy guidance that if properly implemented, will help resolve the

problems we identified during our work.

4. DOD states that the necessary controls are in place to ensure selected

capital projects match long-range plans of the DBOF activity. As support, it

refers to new budget guidance that was issued in May 1994 and the new

economic analysis policy for capital projects. During our work, however,

we found a more basic problem. As we report, the activities we visited

were not preparing long-range plans either because they lacked the

resources to do so, or thought the requirement had been eliminated.

Regardless of the reason, they were not attempting to match large capital

Page 35 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

purchase needs to the long-term future of that activity. In addition, we

found little evidence that any of the review levels in the services or the

Office of the Secretary of Defense (OSD) were performing this function;

local managers were being relied upon to identify the projects they

thought most appropriate for the budget.

More importantly, criteria already exists that requires long-range plans and

the matching of capital asset projects to those needs. While we are

recommending that the new policy include requirements to match capital

asset needs to long-range plans, we also recognize that the policy is not

enough. As stated in the report, DOD must also address long-standing

cultural issues and develop ways to ensure that the policies are effectively

implemented.

5. DOD was developing its new policies for acquiring capital investments as

we completed our work and did not finalize them until after it had

received our report for comment. Consequently, we have adjusted our

report to recognize that the new policies have been completed.

6. We are aware that the military services and other defense components

were involved in developing the new policy but do not believe that is

enough to ensure effective implementation. The problems we describe in

this report are long-standing deficiencies that will likely require direct

intervention and continued management oversight and attention to

correct. Our recommendations were developed with these long-term

requirements in mind.

7. When we prepared our draft report, the DBOF Policy Committee charged

with developing DOD’s new capital investment policy had agreed to

eliminate the requirement to perform post-investment analyses for capital

assets. The majority position of this committee was that limited resources

should not be used to measure, track, and evaluate sunk investment costs.

The DOD comptroller added the requirement to perform post-investment

analyses when he approved the statement on August 8, 1994. Unless DOD

develops a tracking and accountability system, as we recommend,

compliance with this post-investment policy may not be any better than it

was with the last one.

8. DOD agrees with our recommendation to update the DBOF capital budget

by identifying projects canceled or deferred since the last budget and

those that have taken their place. It proposes to do this, however, for only

those projects over $500,000 that are shown as separate line items in the

Page 36 GAO/NSIAD-95-20 Defense Budget
Appendix II 

Comments From the Department of Defense

budget. This, in our view, is not enough to keep the Congress fully

informed of DOD’s progress in bringing stability to the capital budgeting

process. As we show in this report, the DBOF activities we visited canceled

or postponed 86 percent and 65 percent of their budgeted projects during

fiscal years 1993 and 1994, respectively. Because only 3.3 percent (15 of

456) of these canceled or deferred projects were under $500,000, DOD’s

proposal to report only on those over $500,000 will do little to keep the

Congress informed. An alternative we discussed with DOD comptroller

officials was to report on a project-by-project basis for projects over

$500,000 and to report in a summary manner on those projects under

$500,000. This will give the Congress information similar to that in this

report and serve as an effective measure of DOD’s progress in implementing

its new DBOF capital investment policy.

9. DOD agrees with our recommendation for training the key people

responsible for implementing the new guidance. As a solution, however, it

is planning to incorporate economic analysis modules into existing

training courses that are generally made available to its workforce.

Comptroller representatives estimated that it could take 2, 3, or more

years to cycle its key budget analysts, comptrollers, and management

analysts through these courses. Although this is certainly an important

component of training that is past due, we do not believe it will address

the more immediate need to ensure that managers responsible for

developing the DBOF capital budget understand and implement the new

policy and budget guidance.

10. DOD does not identify any mechanisms or performance measures it will

develop to track implementation of the new guidance. Without this type of

information, it will be difficult to know how well the new policy is being

implemented or to identify the managers who are not adequately adhering

to the new requirements.

Page 37 GAO/NSIAD-95-20 Defense Budget
Appendix III 

Scope and Methodology

We performed our audit work at the DOD Comptroller’s Office, military

services, and defense agency headquarters as well as the three command

and six field activity locations listed in table III.1.

Table III.1: DOD Organizations Visited

Service Business area Command and field activity

Army Depot

maintenance

Depot System Command

— Letterkenny Army Depot

— Tobyhanna Army Depot

Navy Research and

development

Naval Air Systems Command

— Naval Air Warfare

 Center, Warminster

— Naval Air Warfare

 Center, Lakehurst

Air Force Depot

maintenance

Air Force Materiel Command

— San Antonio Air

 Logistics Center

Air Force Supply

management

Air Force Materiel Command

— San Antonio Air

 Logistics Center

We selected these locations to cover a cross-section of DBOF business

areas and expected volume of capital investment projects. We interviewed

responsible agency personnel and obtained pertinent documentation as it

related to the DBOF process for capital project budget preparation and

review.

To determine the extent to which DOD carries out the DBOF Capital Budget

it sends to the Congress, we (1) identified the universe of capital projects

included in the fiscal years 1993 and 1994 capital budget for the activities

we visited and (2) compared them to the projects actually undertaken

during those 2 fiscal years.

To assess the effectiveness of the budget preparation and review process

and determine if capital projects are adequately justified and economically

supported, we (1) reviewed the DOD policies, procedures, and guidance

used to prepare and review capital budget projects and (2) identified

internal controls in place to ensure that capital projects are selected in

accordance with the procedures and guidance.

We judgmentally sampled 56 of 140 capital projects included in the various

fiscal year 1994 budget submissions for the activities we visited. In

selecting projects, we placed more emphasis on capital projects over

$500,000. For all 56 projects, we (1) determined whether there was

Page 38 GAO/NSIAD-95-20 Defense Budget
Appendix III 

Scope and Methodology

adequate documentation justifying the project, including, where

appropriate, a properly prepared economic analysis and (2) examined,

when applicable, the reasons for project cancellations and postponements.

Page 39 GAO/NSIAD-95-20 Defense Budget
Appendix IV 

Major Contributors to This Report

National Security and

International Affairs

Division, Washington,

D.C.

David R. Warren

James E. Hatcher

Edward J. Rotz

Joseph A. Margallis

Audrey M. Petit

George C. Surosky

Melissa Niedosik

Calvin E. Phillips

Donald R. McCuistion

Office of Chief

Economist

Harold J. Brumm

(398135) Page 40 GAO/NSIAD-95-20 Defense Budget
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