Report to the Chairman and Ranking

Minority Member, Special Oversight

Panel on Morale, Welfare, and

Recreation, Committee on Armed

Services, House of Representatives

United States General Accounting Office

GAO

August 2001 DEFENSE

MANAGEMENT

Better Guidance

Needed in Selecting

Operating Methods for

Name-Brand, FastFood Restaurants

GAO-01-683
Page i GAO-01-683 Defense Management

Letter 1

Results in Brief 3

Background 5

The Indirect Method Has Been More Profitable for the Exchange

Services 7

Factors Other Than Profitability Are Important When Choosing an

Operating Method 16

DOD’s Policy Lacks Guidance for Evaluating Operating Methods

and Criteria for Approving Deviations From the Policy 20

Conclusion 22

Recommendation for Executive Action 22

Agency Comments 23

Appendix I Scope and Methodology 25

Appendix II Fiscal Year 1999 Inventory of AAFES and NEXCOM

Fast-Food Restaurants 32

Appendix III Comments From the Department of Defense 33

Appendix IV Staff Acknowledgments 36

Glossary 37

Tables

Table 1: Fiscal Year 1998 and 1999 AAFES and NEXCOM

Hamburger Restaurants’ Profitability (For the Periods

Feb. 1, 1998 – Jan. 31, 1999, and Feb. 1, 1999 – Jan. 31,

2000) 8

Table 2: Profitability of Name-Brand, Hamburger Restaurants by

Sales Volume 11

Table 3: Profitability of Name-Brand, Hamburger Restaurants by

Restaurant Type 11

Contents
Page ii GAO-01-683 Defense Management

Table 4: Profitability of Name-Brand, Hamburger Restaurants by

Location 12

Table 5: 20-Year Net Present Value of Discounted Cash Flows for

the Direct and Indirect Methods – Free-standing and Food

Court Name-Brand, Hamburger Restaurants (Fiscal Years

1998 and 1999) 13

Table 6: Factors That Benefit the Direct and Indirect Methods 16

Figure

Figure 1: Military Exchanges’ Food Sales for Fiscal Year 1999 6

Abbreviations

AAFES Army and Air Force Exchange Service

DOD Department of Defense

NEXCOM Navy Exchange Service Command

MCCS Marine Corps Community Services

MWR morale, welfare, and recreation
Page 1 GAO-01-683 Defense Management

August 24, 2001

The Honorable Roscoe G. Bartlett

Chairman

The Honorable Robert A. Underwood

Ranking Minority Member

Special Oversight Panel on

 Morale, Welfare, and Recreation

Committee on Armed Services

House of Representatives

The military exchange services operate a wide range of retail activities

such as department stores, florist shops, barber and beauty shops,

gasoline stations, and restaurants. Profits from these activities provide

funds for the Department of Defense’s (DOD) morale, welfare, and

recreation programs. In recent years, the exchange services’ annual sales

exceeded $9 billion—in fiscal year 1999 about $734 million involved food

operations.1

 About 50 percent of the food sales came from about 615

name-brand, fast-food restaurants (e.g., McDonald’s, Burger King, Subway,

and Pizza Hut) operating on military installations around the world.

Name-brand, fast-food restaurant operations, particularly hamburger

restaurants, are the topic of this report. It focuses on hamburger

restaurants because they represent a major segment of the exchange

services’ name-brand, fast-food sales and because exchange services’

contracts with two large companies, Burger King and McDonald’s, will

expire in 2004.

The exchange services use either a direct or an indirect method to operate

name-brand, fast-food restaurants. A DOD policy, issued in 1988,

expresses a preference for the direct method at overseas installations and

the indirect method at U.S. installations. Under the direct method, the

exchange service enters into a franchise agreement with a name-brand

company to sell its product on a military installation. As the franchisee, the

exchange service builds and operates the restaurants and directly employs

and trains the personnel. In return, the exchange service receives all

revenues and profits and usually pays the company a licensing fee plus a

 1

 The sales total includes sales from activities operated by the exchange service and from

activities operated by concessionaires under contract with the exchange services, which

include some food operations.

United States General Accounting Office

Washington, DC 20548
Page 2 GAO-01-683 Defense Management

percentage of the restaurant sales. Under the indirect method, the

exchange service contracts with a name-brand company that, in turn,

builds the restaurant and either operates it as a company restaurant or

provides a licensed operator. The company or its licensed operator hires,

trains, and pays the restaurant personnel and usually pays annual fees and

commissions to the exchange service based on restaurant sales. Under this

arrangement, the exchange service receives a percentage of the

restaurants’ annual sales, annual licensing fees, and, in some cases, a

signing bonus and/or minimum guaranteed commissions. The size of the

bonus and guaranteed payments are determined through negotiations.

With respect to name-brand, hamburger operations, the Army and Air

Force Exchange Service uses the direct method to operate most of its

hamburger restaurants, which are primarily Burger King, while the Navy

Exchange Service Command uses the indirect method to operate most of

its restaurants, which are primarily McDonald’s.

In June 2000, representatives of the largest exchange service, the Army

and Air Force Exchange Service, briefed a member of the House Special

Oversight Panel on the profitability of the direct and indirect methods of

operating name-brand, fast-food restaurants on military installations.

Because the briefing did not address all of the Panel member’s questions

about the costs and profitability of the two methods, the former Chairman

and Ranking Minority Member of the Special Oversight Panel asked us to

review the two methods. This report discusses (1) which method is more

profitable2

 and provides the greater return on investment; (2) other factors

that can influence the choice between the direct and indirect methods; and

(3) whether DOD’s policy on name-brand, fast-food operations provides

adequate guidance for determining which method to use.

Our analysis of profitability and return on investment compared only the

name-brand, hamburger restaurants operated by the two largest exchange

services—the Army and Air Force Exchange Service and the Navy

Exchange Service Command. Sales from these restaurants, primarily

 2

 In this report, the terms “profit” and “profitability” refer to economic earnings for the

direct method of operation or net profit for the indirect method of operation. Throughout

this report, profits and profitability are expressed as a percentage of restaurant sales.

Profitability under the direct method represents a restaurant’s total revenues less its

operating costs, overhead costs, and the opportunity cost associated with invested capital

(also known as cost of capital). Profitability under the indirect method represents the

revenues (sales commissions, signing bonuses, and licensing fees) received from the namebrand company less the exchange service’s overhead costs. Profitability and cost of capital

are discussed in more detail in appendix I.
Page 3 GAO-01-683 Defense Management

Burger King and McDonald’s, represented about 50 percent of the

exchange services’ total name-brand, fast-food sales in fiscal years 1998

and 1999, the 2 years that formed the basis of our analysis.3 Our analysis of

profitability involved and relied on information provided to us by the

exchange services. We performed procedures to evaluate the

reasonableness of the exchange services’ data but did not verify its

accuracy or reliability. More information on the scope and methodology of

our work is included in appendix I.

Our analysis of fiscal year 1998 and 1999 financial data from the two

exchange services showed that the indirect method of operating

name-brand, hamburger restaurants was more profitable than the direct

method. In each of the 2 years, for example, the Navy Exchange Service

Command’s profits were about 11.5 percent of restaurant sales. In

comparison, the Army and Air Force Exchange Service’s profits were

7.8 percent and 5.5 percent of restaurant sales, respectively. The indirect

method was also more profitable, regardless of the restaurants’ sales

volume, restaurant type (free-standing or part of a food court), or location

(continental United States or overseas). Also, our investment analysis

projected that if new name-brand, hamburger restaurants were to be built,

the indirect method would provide a greater return on investment over a

20-year period.4

Profitability or return on investment, however, has not always been the

deciding factor when military exchanges select an operating method for

fast-food restaurants. Other factors (e.g., financial and operating risks,

customer service issues, employment opportunities for military

dependents, and management control of restaurant operations) were also

important in choosing between the direct and indirect methods. Officials

of the Army and Air Force Exchange Service said that the direct method

best suits their mission objectives because the exchange can directly

operate unprofitable restaurants in remote locations or overseas for the

purpose of maintaining or boosting servicemembers’ morale. Name-brand

 3

 In general, the fiscal year for the exchange services covers the period from February 1st

of a given year to January 31st of the following year. This period is consistent with the

fiscal year used by the retail industry.

4

 The investment analysis was based on present value techniques that consider variables

such as sales, costs, capital investment requirements, and inflation rates. In essence, the

analysis compared discounted cash flows, both outlays and revenues, expected over a

20-year period. This analytical technique is discussed in more detail on p. 12 and in

appendix I.

Results in Brief
Page 4 GAO-01-683 Defense Management

companies operating under the indirect method are not likely to build and

operate restaurants in such dangerous or unprofitable locations. The

direct method also provides the exchange service with greater

management control over restaurant operations and more flexibility in

providing employment opportunities to military dependents. In addition,

the direct method allows the Army and Air Force Exchange Service to

take advantage of its existing infrastructure (i.e., warehousing and

distribution capabilities) to support rapid mobilizations to such locations

as Bosnia. On the other hand, the indirect method requires very little, if

any, investment. The Navy Exchange, for example, has no capital invested

in its 64 restaurants, which were built by a name-brand, food service

company, while the Army and Air Force Exchange Service has invested

over $131 million in its 171 hamburger restaurants. The indirect method

also minimizes the potential liabilities and risks associated with operating

restaurants and reduces the federal government’s competition with the

private sector, which is one of the objectives of the Department’s fast-food

policy.

While DOD’s policy on name-brand, fast-food restaurants establishes

preferences for when the direct and indirect methods should be used, it

does not provide sufficient guidance or criteria for determining which

method to use or when it is appropriate to deviate from the policy. In

addition, DOD has not been actively involved in monitoring compliance

with the policy. As a result, the exchanges have, over time, adopted

operating philosophies and business models that they believe best suit

their particular circumstances. Because of the exchanges’ preferences and

operating philosophies, they do not routinely develop a business case

analysis, which would include weighing financial benefits with other

factors, when determining which operating method would be the most

beneficial. However, a 1998 departmental instruction, which addresses

public-private ventures, has the potential to give greater visibility to this

issue.5

 The instruction requires the exchange services to consider

public-private ventures as an alternative source to meet capital

requirements that exceed $1 million. Each public-private venture requires

an economic analysis. Also, it is to be reviewed by DOD policy officials

when it involves an overseas restaurant or liabilities to the government or

 5

 A public-private venture, as used here, is an agreement between a DOD nonappropriated

fund activity, such as an exchange service, and a non-federal entity under which the entity

provides goods, services, or facilities to authorized morale, welfare, and recreation

activities and exchange patrons. The non-federal entity may provide a portion or all of the

financing, design, construction, equipment, and staffing associated with the activity.
Page 5 GAO-01-683 Defense Management

a nonappropriated fund activity in excess of $500,000. Thus far, however,

the instruction has had no impact on the exchange services’ restaurant

operations because contracts for most name-brand, fast-food restaurants

were in place before the instruction was issued. Moreover, it is not yet

clear how the instruction will be integrated with DOD’s name-brand,

fast-food policy.

We are making recommendations to improve the Department of Defense’s

policy for operating name-brand, fast-food restaurants by clarifying when

deviations from the policy can occur and by developing a more formal

decision-making process for choosing between the direct and indirect

methods of operation. In written comments on a draft of this report, DOD

concurred with our conclusions and recommendations.

The military exchanges are nonappropriated fund activities that are

established, controlled by, and operated for the benefit of DOD

components. Their mission is to provide (1) authorized patrons with

articles and services necessary for their health, comfort, and convenience

and (2) DOD’s morale, welfare, and recreation (MWR) programs with a

source of funding. In carrying out this dual mission, the exchanges operate

retail stores, similar to department stores, and provide a host of other

services and specialty stores, including furniture stores, florist shops,

barber and beauty shops, optical shops, liquor stores, and fast-food

restaurants. For fiscal year 1999, the exchange services had over $9 billion

in sales. For the past several years, about 70 percent of the exchange

services’ profits from sales were allocated to MWR activities and about 30

percent to new exchange facilities and related capital projects.

Military exchange services’ food operations generated about $734 million

in sales during fiscal year 1999, or about 8 percent of the exchanges’ total

sales. The sales occurred at about 2,200 food outlets operated by three

military exchanges—the Army and Air Force Exchange Service (AAFES),

the Navy Exchange Service Command (NEXCOM), and the Marine Corps

Community Services (MCCS).6

 These outlets, located on military

installations around the world, included name-brand, fast-food

restaurants, in-house signature brand restaurants, and more generic food

operations such as cafeterias and snack bars. As shown by figure 1, over

 6

 AAFES and NEXCOM operate as separate nonappropriated fund entities. Exchange

operations that support the Marine Corps are combined with all MWR activities and are

managed by MCCS. Sales totals presented in the background section of this report include

restaurants managed by MCCS as well as the other exchange services.

Background
Page 6 GAO-01-683 Defense Management

50 percent of the $734 million in sales came from name-brand, fast-food

outlets.

Figure 1: Military Exchanges’ Food Sales for Fiscal Year 1999

Source: GAO analysis of AAFES, NEXCOM, and MCCS financial data.

Modern name-brand, fast-food restaurants began to appear on military

installations in the early 1980s. In 1984, the Burger King Corporation and

AAFES signed a 20-year, master contract authorizing AAFES to construct

and operate 185 Burger King restaurants around the world. Each Burger

King restaurant has a separate contract consistent with the terms of the

master contract. Also in 1984, NEXCOM awarded a 10-year, master

contract to McDonald’s Corporation. This contract, which was

recompeted and renewed in 1994, allowed McDonald’s to construct and

operate restaurants at more than 40 locations around the world. Both

Burger King and McDonald’s contracts will expire in 2004.

Today, other national brands, such as Baskin Robbins, Kentucky Fried

Chicken, Pizza Hut, Popeye’s Chicken & Biscuits, Subway, Taco Bell, and

Wendy’s, can also be found on military installations. (See app. II for the

number of facilities and sales totals for AAFES and NEXCOM fast-food
Page 7 GAO-01-683 Defense Management

operations.) Fast-food restaurants are generally categorized by their

location, size, and/or physical characteristics. A free-standing restaurant is

often referred to as a traditional or stand-alone restaurant—it is located in

a separate, distinct building with signage and logos that clearly identify its

brand. A restaurant located in a food court is often referred to as a

non-traditional or in-line restaurant. Free-standing restaurants are usually

larger in size and have higher sales volumes than those found in food

courts.

The Assistant Secretary of Defense (Force Management) is responsible for

establishing uniform policies for armed services exchange operations.7

 In

that capacity, the Assistant Secretary issued a policy memorandum for

name-brand, fast-food operations in January 1988. The policy

memorandum, which responded to recommendations from the House

Committee on Armed Services, was issued to control the proliferation of

fast-food restaurants on military installations and avoid a “fast-food strip”

effect, award business to American investors, and ensure that name-brand,

fast-food prices on military installations in the United States were

comparable to those in communities adjacent to the military installation.

The memorandum stated that the policy would be strictly followed and

any deviations had to be approved in writing by the Assistant Secretary.

However, the memorandum provided no criteria for approving a deviation.

In addition, the primary armed services regulations governing MWR

activities and the exchange services give the secretaries of the military

services a stake in prescribing and overseeing the activities that can

operate on their facilities, including the method that will be used to

operate fast-food restaurants.8

Our analysis of fiscal year 1998 and 1999 financial data showed that the

indirect method of operating name-brand, hamburger restaurants provided

greater profitability than the direct method. This was true regardless of

whether the restaurants were grouped and analyzed by sales volume,

restaurant type (stand-alone or part of a food court), or location

(continental United States or overseas). We also projected that if new

 7

 The Assistant Secretary reports to the Under Secretary (Personnel and Readiness) who, in

turn, reports to the Deputy Secretary of Defense.

8

 DOD Directive 1015.1, Establishment, Management, and Control of Nonappropriated Fund

Instrumentalities, dated April 8, 1986, and DOD Directive 1330.9, Armed Services Exchange

Regulation, dated December 15, 1986.

The Indirect Method

Has Been More

Profitable for the

Exchange Services
Page 8 GAO-01-683 Defense Management

name-brand, hamburger restaurants were to be built, the indirect method

would result in a higher return on investment over a 20-year period. In

conducting our analyses, we found that the exchange services had

appropriately considered the various types of costs of their fast-food

operations, except for overhead. We included overhead costs and the cost

of capital in our analyses.

For fiscal years 1998 and 1999, NEXCOM’s profits on 64 indirectly

operated hamburger restaurants were about 11.5 percent and 11.4 percent,

respectively, when measured as a percentage of total sales. Over the same

period, AAFES’ profits on 164 and 171 directly operated hamburger

restaurants were 7.8 and 5.5 percent, respectively. Table 1 provides the

results of our analysis.

Table 1: Fiscal Year 1998 and 1999 AAFES and NEXCOM Hamburger Restaurants’ Profitability (For the Periods Feb. 1, 1998 –

Jan. 31, 1999, and Feb. 1, 1999 – Jan. 31, 2000)

Dollars in thousands

Fiscal year 1998 Fiscal year 1999

AAFES’ direct

method

NEXCOM’s indirect

method

AAFES’ direct

method

NEXCOM’s indirect

method

Total

Percent

of sales Total

Percent

of sales Total

Percent

of sales Total

Percent

of sales

Number of

restaurants

164 64 171 64

Total sales $ 183,985 100.0 $ 66,392 100.0 $176,435 100.0 $ 67,430 100.0

Total revenuesa 184,336 100.2 8,006 12.1b 176,632 100.1 8,121 12.0b

Operating costsc155,653 84.6 N/AdN/Ad152,555 86.5 N/AdN/Ad

Overhead costs 9,015 4.9 359 0.5 9,051 5.1 421 0.6

Net profit 19,668 10.7 7,648 11.5 15,026 8.5 7,700 11.4

Cost of capitald5,358 2.9 N/AeN/Ae5,354 3.0 N/AeN/Ae

Economic earnings $ 14,310 7.8 $ 7,648 11.5 $ 9,672 5.5 $ 7,700 11.4

Note: Figures may not total due to rounding.

a

Revenues under the direct method include restaurant sales plus other income, which is primarily the

proceeds from selling surplus equipment and additional revenue realized in overseas locations from

foreign currency conversions at the point of sale. Revenues under the indirect method are

commissions based on restaurant sales plus licensing fees and signing bonuses.

b

An alternative way of expressing NEXCOM’s profitability would be as a percentage of total revenues.

Revenues under the indirect method are not restaurant sales but are payments (sales commissions,

signing bonuses, and licensing fees) to an exchange service from the name-brand, fast-food

company based on restaurant sales. If expressed as a percentage of revenues, NEXCOM’s profits

would be 95.5 and 94.8 percent, respectively, for fiscal years 1998 and 1999.

c

Operating costs include the cost of goods sold and depreciation.

Financial Analyses Show

That the Indirect Method

Provided Greater

Profitability
Page 9 GAO-01-683 Defense Management

d

Cost of capital represents the opportunity cost (or economic cost) associated with alternative uses for

invested capital of comparable risk. For AAFES, this would include funds invested in buildings and

equipment (including periodic renovations and upgrades) and inventory. AAFES used a cost of capital

of 10 percent for both fiscal years. We applied a cost of capital charge to the average inventory value

and the undepreciated value of assets associated with AAFES’ Burger King restaurants.

e

N/A is being used to note that, under the indirect method, NEXCOM does not have operating costs

or a cost of capital. These costs are borne by the name-brand, fast-food company or restaurant

operator.

Source: Our analysis of AAFES and NEXCOM fiscal year 1998 and 1999 financial data.

Although the table does not show major differences in results between

fiscal years 1998 and 1999, we have several observations about the

profitability of the two alternatives.

• For servicemember morale purposes, AAFES operates a number of

unprofitable Burger King restaurants in remote locations and overseas.

In fiscal year 1999, for example, 56 of its 171 Burger King restaurants

lost a combined $2.7 million. Eliminating these 56 restaurants from our

analysis showed that the remaining 115 restaurants had profits of 9.2

percent of restaurant sales—this compares more favorably with

NEXCOM’s 11.4 percent for that year.

• AAFES’ overhead rates (4.9 percent and 5.1 percent of sales) were

significantly higher than NEXCOM’s (0.5 percent and 0.6 percent of

sales) because of the different operating method. AAFES’ overhead

rates captured the numerous support activities needed to manage the

large infrastructure, distribution network, and personnel associated

with the exchange’s operations. NEXCOM, on the other hand, had only

a small number of support personnel to oversee its contracts with

McDonald’s.

• NEXCOM’s revenues under the indirect method were derived from

one-time signing bonuses, minimum guarantees, and annual licensing

fees as well as commissions on restaurant sales. Signing bonuses and

licensing fees accounted for approximately 25 percent of the revenues.

• Neither AAFES nor NEXCOM had established overhead rates for its

restaurant operations. Therefore, we used the AAFES exchangewide

rates, which are the rates AAFES applied to its overall operations for

each of the 2 fiscal years. In response to our review, NEXCOM

computed overhead rates that showed its limited support costs for

overseeing its food service contracts.

• AAFES applied a 10-percent cost of capital to its restaurant operations,

which, when measured as a percentage of sales, was 2.9 and 3.0

percent, respectively, for fiscal years 1998 and 1999. Because NEXCOM

relies on McDonald’s and its licensed operators to build and

periodically renovate the restaurant facilities, it had no capital costs.
Page 10 GAO-01-683 Defense Management

• AAFES’ restaurant sales decreased about 4 percent between fiscal year

1998 and 1999 while its operating costs, as a percentage of sales,

increased about 2 percent. These changes did not appear to be related

to the method used to operate the restaurants.

• Both AAFES and NEXCOM rely on the military services for certain real

property maintenance activities, particularly for repairs to the exterior

of the restaurant building and the surrounding property. The

exchanges, however, did not show these costs, and they were not

readily available from the military services. In addition, both exchanges

received similar support, which would tend to mitigate the cost impact

on relative profitability. Therefore, we did not include them in our

analysis.

As part of our analysis, we evaluated the profitability of both methods

from several perspectives—by sales volume, restaurant type (free-standing

or food court), and location (continental United States or overseas). Each

analysis showed that the indirect method was more profitable.

• Profitability by Sales Volume: We arrayed AAFES’ directly operated

and NEXCOM’s indirectly operated restaurants by annual sales

volumes. As shown in table 2, the profitability of both types of

restaurants improved as sales volumes increased. However, NEXCOM’s

profits measured as a percentage of sales were higher than AAFES’ in

all categories for both fiscal years. For some categories, such as sales

over $500,000 but less than $1 million, they were more than twice as

high. For example, in fiscal year 1998, AAFES’ restaurants had profits

of 3.0 percent of sales while NEXCOM’s restaurants had profits of

6.6 percent of sales. AAFES’ profitability was negatively affected by a

large number of smaller restaurants that lost money in fiscal years 1998

and 1999. In 1999, for example, 44 of its 97 restaurants with sales under

$1 million lost money. As table 2 shows, AAFES’ restaurants with sales

of $500,000 or less lost 3.1 percent of sales and 1.7 percent of sales for

fiscal years 1998 and 1999, respectively.

Indirect Method Was More

Profitable Under Various

Scenarios
Page 11 GAO-01-683 Defense Management

Table 2: Profitability of Name-Brand, Hamburger Restaurants by Sales Volume

Fiscal year 1998 Fiscal year 1999

Sales volume

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

$0 to $500,000 -3.1a2.4 5.5 -1.7a2.4 4.1

Over $500,000 to

$1 million

3.0 6.6 3.6 0.9 6.8 5.9

Over $1 million to

$1.5 million

7.7 10.8 3.1 6.6 11.5 4.9

Over $1.5 million 10.9 15.0 4.1 9.0 14.8 5.8

a

These percentages are preceded by a minus sign to indicate that AAFES’ restaurants in this sales

volume category collectively lost money in both 1998 and 1999.

Source: Our analysis of AAFES and NEXCOM financial data.

• Profitability by Restaurant Type: Both AAFES and NEXCOM operate

traditional or free-standing hamburger restaurants and smaller

non-traditional or food court type restaurants. As shown in table 3,

free-standing restaurants, which tend to have higher sales volumes,

were more profitable than restaurants located in a food court.

NEXCOM’s average profits, however, were higher in both fiscal years

for each type of restaurant.

Table 3: Profitability of Name-Brand, Hamburger Restaurants by Restaurant Type

Fiscal year 1998 Fiscal year 1999

Restaurant type

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

Free standing 9.1 12.4 3.3 6.6 11.9 5.3

Food court 2.6 8.2 5.6 2.0 9.8 7.8

Source: Our analysis of AAFES and NEXCOM financial data.

• Profitability by Location: About 60 percent of AAFES’ restaurants and

80 percent of NEXCOM’s restaurants are located within the continental

United States. As shown in table 4, NEXCOM’s indirectly operated

restaurants were more profitable, regardless of their location. The

biggest difference in profitability, however, was in restaurants located

outside the continental United States. In fiscal year 1999, for example,

the 69 overseas restaurants operated directly by AAFES had profits

that averaged about 2 percent of sales, or $21,000 per restaurant.

Almost half of its overseas restaurants, which were located in various
Page 12 GAO-01-683 Defense Management

countries around the world, lost money in 1999. On the other hand,

NEXCOM’s 12 overseas restaurants had average profits of about

14 percent of sales, or about $224,000 per restaurant.

Table 4: Profitability of Name-Brand, Hamburger Restaurants by Location

Fiscal year 1998 Fiscal year 1999

Location of

restaurant

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

AAFES’ direct

method (profits

expressed as

percent of sales)

NEXCOM’s indirect

method (profits

expressed as

percent of sales) Difference

United States 9.3 10.2 0.9 7.9 10.4 2.5

Overseas 5.6 15.3 9.7 2.0 14.0 12.0

Source: Our analysis of AAFES and NEXCOM financial data.

In addition to our profitability analysis of fiscal year 1998 and 1999

financial data, we performed a 20-year, cash flow analysis for a capital

investment in a new name-brand, hamburger restaurant. This analysis

showed that the indirect method would produce about twice the net cash

flow, in current-year dollars, as the direct method. A recent Army

consultant’s study reached a similar conclusion.

A cash flow analysis is a technique that is sometimes used at the beginning

of a project to assess investment alternatives or strategies. Net present

value techniques can show, in today’s dollars, the relative net cash flow of

various alternatives over a long period of time—in the case of our study,

20 years. Simply stated, net cash flow is the amount of dollars that is left

after sales or revenues have offset expenses. In general, the greater the net

cash flow for a particular investment, the greater the return on the

investment. In conducting this analysis, we combined the fiscal year 1998

and 1999 data for both AAFES and NEXCOM and calculated average

annual sales, net profit, and depreciation per restaurant for free-standing

and food court restaurants. In conducting our analysis, we assumed that

the financial data would remain constant over the 20-year period. We also

made a number of assumptions about factors such as the frequency of

renovations (which require incremental capital investments), inflation

rates, and the exchange services’ cost of capital. Using the data and

applying the assumptions, we discounted the restaurants’ projected cash

flows for a 20-year period. The methodology we used for the analysis is

discussed more thoroughly in appendix I.

As indicated in table 5, our analysis shows that over a 20-year period the

direct method has a significantly lower net cash flow, in today’s dollars,

Investment Analysis

Projected That the Indirect

Method Would Provide a

Greater Return on

Investment if New

Restaurants Were Built
Page 13 GAO-01-683 Defense Management

for both free-standing and food court restaurants than the indirect method.

This is due primarily to the significant initial investment, shown as

$1,025,000 for the free-standing restaurant and $375,000 for the food court

restaurant, required to build and equip the facilities and the subsequent

periodic capital improvements that are required about every 5 years by

AAFES’ contract with Burger King. We also performed a number of other

cash flow analyses using alternative assumptions (see app. I). While the

bottom-line numbers changed somewhat, the overall results were

generally the same.

Table 5: 20-Year Net Present Value of Discounted Cash Flows for the Direct and Indirect Methods – Free-standing and Food

Court Name-Brand, Hamburger Restaurants (Fiscal Years 1998 and 1999)

Free-standing restaurants Food court restaurants

AAFES operated

under direct method

NEXCOM operated

under indirect method

AAFES operated

under direct method

NEXCOM operated

under indirect method

Financial information:

 Sales per restaurant $ 1,348,598 $ 1,282,381 $ 634,845 $ 637,216

 Net profit per restaurant 146,054 156,109 34,849 57,510

 Depreciation per restauranta52,058 N/A 37,654 N/A

Capital requirements:

 Initial facility, equipment, and

 fixtures

$ 1,025,000 N/A $ 375,000 N/A

 Incremental capital

 investment applied in years

 5, 10, and 15

100,000 N/A 25,000 N/A

Economic assumptions:

 Real cost of capitalb7.5% N/A 7.5% N/A

Discounted cash flows:

 Year 0 $ -1,025,000 0 $ -375,000 0

 Year 1-4 663,543 $ 522,861 242,836 $ 192,618

 Year 5 68,341 108,739 33,089 40,059

 Year 6-9 462,196 364,203 169,150 134,170

 Year 10 47,603 75,743 23,048 27,903

 Year 11-14 321,947 253,689 117,823 93,457

 Year 15 33,159 52,760 16,054 19,436

 Year 16-20 270,893 213,459 99,139 78,637

Net present value of

cash flows

$ 842,682 $ 1,591,454 $ 326,138 $ 586,280

a

Annual depreciation expense was added to annual net profit to determine the annual cash flow.

Although depreciation is an expense that reduces net profit, it does not involve cash payments.

Therefore, we included depreciation in the calculation of cash flows for the direct method.
Page 14 GAO-01-683 Defense Management

b

Because the current projection of future inflation is about 2.5 percent, we subtracted this rate from

AAFES’ 10 percent nominal cost of capital rate to arrive at a real cost of capital rate of 7.5 percent.

We also conducted this analysis using cost of capital rates of 7 percent and 8 percent to determine if

changes in the rate would affect the outcome of the analysis. Under these scenarios, the indirect

method still produced higher net cash flows, in today’s dollars, than the direct method.

Source: Our analysis of AAFES and NEXCOM financial data.

The Army, which plans to open name-brand, fast-food restaurants at some

of its MWR activities, sponsored a study in April 2000 to determine which

method—direct or indirect—would provide the greatest returns on its

investment. This study, which was conducted by a consulting firm in the

food and hospitality industry, used the net present value technique to

project cash flows for five different name-brand food types—hamburgers,

chicken, pizza, Mexican, and sandwiches. The study was based on sales,

cost, overhead, and profit data from AAFES, NEXCOM, and industry

sources. It applied the data to a 10-year investment period and concluded

that the indirect method provided more cash flows for both free-standing

and food court hamburger restaurants and generally was the best value for

the Army’s MWR activities.

Our analysis of AAFES and NEXCOM financial data showed that the

exchanges had, with only one exception, considered the various types of

costs associated with their fast-food operations. The one exception was

overhead. Neither AAFES nor NEXCOM used overhead costs when

determining the profits associated with its individual restaurants.

At AAFES, we found that it did not include overhead costs when reporting

profits from fast-food operations. Instead, it calculated and applied an

exchangewide overhead rate to its total operations to determine

exchangewide profits. In doing this, AAFES accumulated its general and

administrative costs from local exchanges and regional and headquarters

operations. Its overhead rates were 4.9 percent of sales and 5.1 percent of

sales for fiscal years 1998 and 1999, respectively. We compared the rates

with overhead rates of fast-food restaurants in the private sector and

found that the AAFES rates were reasonable. We also reviewed the work

completed by AAFES’ internal auditors that related to reviewing the

exchangewide overhead rates. We concluded that the methodology used

by the internal auditors to review the rates was reasonable. Before using

the exchangewide rates for our analysis, however, we asked AAFES food

service and financial management officials if they had an overhead rate for

just fast-food operations. They responded in writing, as well as in several

follow-up discussions on this topic, that they did not have such a rate.

They told us that previous efforts to develop one had proved too difficult

because of the way costs were accumulated and accounted for.

Except for Overhead,

Exchanges Considered the

Various Types of Costs

When Assessing Fast-food

Operations
Page 15 GAO-01-683 Defense Management

Accordingly, we used the 4.9 percent and 5.1 percent rates in our analysis

of 1998 and 1999 financial data.

However, after completing our work at AAFES, representatives of AAFES

informed us they had developed overhead rates specifically for namebrand, hamburger restaurants operating under the direct method. The

rates were 3.3 percent for both fiscal years 1998 and 1999. We discussed

the approach AAFES used to develop these new rates but were unable to

readily assess their accuracy because the information AAFES provided

was not sufficient to support the differences in overhead costs between

food service direct operations and exchangewide operations. We assessed

the reasonableness of the new rates by comparing them with the rates of

eight food service companies. All of the companies were included in

Fortune Magazine’s list of top 10 food service companies based on

revenues. This comparison showed that the new rates were substantially

lower than those used by the food service companies included in our

analysis. Based on the results of this comparison, we did not use the new

rates in our detailed analysis shown in table 1. However, if we had used

the revised rates, the profitability of the direct method would remain less

than the indirect method, but the differences would not be as great.

At NEXCOM, we found that it had not considered overhead costs when

assessing the financial results of its fast-food operations. As a result of our

work, the exchange developed overhead rates for its indirect fast-food

operations. The rates developed were 0.5 percent and 0.6 percent of the

franchisees’ sales for fiscal years 1998 and 1999, respectively. We used

these rates in our analyses. Before using the rates, however, we reviewed

the methodology NEXCOM used to develop them. We found that the

methodology and costs included in the overhead rates appeared

reasonable. When compared to AAFES’ overhead rates, NEXCOM’s rates

appeared small. This condition exists because the indirect method

requires significantly fewer people to manage and oversee fast-food

operations. For example, to support such operations, NEXCOM had to

negotiate and oversee several contracts, while AAFES had to manage all of

the operations of about 170 restaurants.
Page 16 GAO-01-683 Defense Management

Exchange officials identified a number of factors, other than profitability,

that are important when deciding between the direct and indirect

methods. As shown in table 6, we grouped these factors into six

categories: financial risk, customer service, employment opportunities,

management control, operational risk, and investment opportunities. The

relative importance of individual factors might vary depending on the

circumstances involved in selecting an operating method for a planned

restaurant. However, neither exchange used a standard approach or

methodology to determine their relative importance or to evaluate them

along with profitability considerations.

Table 6: Factors That Benefit the Direct and Indirect Methods

Benefits applicable to

Benefits

Direct

method

Indirect

method

Financial risk

Minimizes capital investment for buildings, equipment, and fixtures X

May provide revenues, at least in the short term, if restaurant does not make a profit X

Customer service

Serves equivalent American menus at or below local market prices worldwide X X

Serves equivalent American products worldwide X

Provides name-brand food to remote locations that may not be profitable X

Provides name-brand food service overseas X X

Customers are not charged sales tax X

Employment opportunities

Provides job opportunities to members and family X X

Provides employment preference to family members X

Provides portable employment benefits X

Management control

Minimizes the size of the management infrastructure X

Provides direct control over customer service issues X

Can respond quickly to support deployment requirements X

Can change hours of operation to meet military needs X

Provides a single point of contact worldwide to address issues and implement changes X

Reduces construction/renovation cycle time X

Operational risk

Potentially reduces liability for losses and claims X

Minimizes the risk to profits due to poor performance X

Investment opportunities

Minimizes competition with the private sector X

Supports DOD’s policy to assess opportunities for public-private ventures X

Source: Our analysis of information provided by AAFES and NEXCOM.

Factors Other Than

Profitability Are

Important When

Choosing an

Operating Method
Page 17 GAO-01-683 Defense Management

• Indirect Method Minimizes Financial Risk: Under the indirect method,

the name-brand, fast-food company builds the restaurants and assumes

the financial risk of recovering its capital investments and operating at

a profit. The exchange service, in this situation, has no capital

investment and generally receives a commission on restaurant sales,

regardless of whether the restaurant makes a profit. Under the direct

method, the opposite is true. The exchange service provides the capital

for building and periodically updating the restaurant, assumes all

financial risks of operations, and generally pays the name-brand

company an annual licensing fee and a royalty or commission on its

annual sales.

• Both Methods Provide Customer Service: Both methods can be used

domestically and overseas and require the exchange services to offer

menus and prices equivalent to those in the private sector.9

 Under the

direct method, however, an exchange service can establish restaurants

in less profitable, remote locations in order to boost military members’

morale. For example, AAFES officials told us that soon after the

military was deployed to Bosnia for the peacekeeping mission, it

opened three hamburger restaurants. It also opened 14 food service

outlets in the Balkans and Kosovo, including 4 hamburger restaurants,

and it has responded to many other emergencies or humanitarian

deployments over the years. AAFES believes this would not have been

possible under the indirect method because it did not believe namebrand companies would have been willing to operate in such

potentially dangerous or unprofitable locations. In fact, NEXCOM

officials provided us information showing that several restaurants

operating under the indirect method at Navy installations had been

closed during the last several years due to low sales. Nevertheless,

NEXCOM officials believe the indirect method of operation adequately

meets the deployment needs of the Navy, which are fundamentally

different than those of the Air Force and the Army. Moreover,

NEXCOM officials believe some of the name-brand companies that

support its indirect operations are capable of providing emergency

service as well as service to remote locations around the world.

Another advantage of the direct method is that customers do not have

 9

 AAFES officials agreed that both methods offer equivalent menus worldwide. However,

they noted that product consistency, such as the taste of hamburgers, may vary under the

indirect method because concessionaires may have to use local sources of supply rather

than a single supplier. AAFES, on the other hand, is the major supplier for its restaurants

and contends that it can provide a more consistent product overseas.
Page 18 GAO-01-683 Defense Management

to pay sales tax. This advantage provides varying degrees of savings to

the customer, depending on the state and local taxes applicable at each

location.

• Direct Method Provides Greater Employment Opportunities for

Military Dependents: Both methods provide employment opportunities

for military dependents. However, because AAFES has control over the

hiring practices at its directly run restaurants, it gives military spouses

and other family members employment preferences. According to

AAFES, about half of its work force are military dependents, some of

which have worked for years with AAFES as they have moved from

one installation to another. These employees retain their benefits

(medical, sick leave, etc.) when they move as long as they continue to

work for AAFES.

• Direct Method Provides More Control Over Operations: Under the

direct method, the exchange services have more control over

operations. AAFES officials said that this control gives them the ability

to (1) establish restaurant hours that best support military needs,

(2) address customer service issues consistently throughout the AAFES

restaurant network, and (3) support the Army and Air Force mission

objectives, which involve deploying personnel in war zones or other

remote areas throughout the world. With its large supply and

distribution network and access to resources, it can respond quickly to

emergency situations almost anywhere in the world. On the other hand,

the indirect method requires practically no infrastructure because the

name-brand company and/or its restaurant operator handles all

construction and operating issues. NEXCOM personnel agreed that the

indirect method gave the exchange limited operating control of its

restaurants but did not think such control was necessary because it

does not provide fast-food operations on ships. Instead, most of its

restaurants are located at large seaports or bases in the United States

and overseas and generally operate in a normal commercial

environment.

• Indirect Method Limits Operational Risks: Under the indirect method,

the food service company and its restaurant operators are responsible

for achieving sales goals, procuring and managing product inventories,

maintaining the physical plant and equipment, developing promotions

and marketing strategies, planning and updating menus, managing the

food preparation process (including controlling the size of food

portions), hiring and training all personnel, and assuming losses

associated with breakdowns in internal controls. In addition, restaurant
Page 19 GAO-01-683 Defense Management

operators assume the primary risk for workers’ compensation claims

and litigation associated with such things as accidents, harm caused by

products, and employee injuries. Under the direct method, these issues

fall primarily with the exchange service.

• Indirect Method Promotes Private Sector Investment Opportunities:

The indirect method provides investment opportunities for private

sector citizens, who are likely to be members of the local business

community, and reduces concerns about government encroachment

into private-sector functions, one of the objectives of DOD’s 1988 fastfood policy. AAFES officials told us that requests to build name-brand,

fast-food restaurants on a military installation have sometimes been

denied because an existing franchise restaurant would have been

adversely affected. The indirect method is also consistent with DOD’s

more recent 1998 policy to consider public-private ventures as an

alternative for enhancing business activities that support MWR

programs.10 This policy, which involves the indirect method of

operation, calls for the exchange services to consider public-private

ventures as an alternative source to meet capital requirements that

exceed $1 million.

NEXCOM and AAFES officials told us that they need flexibility to

determine how best to meet their mission objectives and satisfy the

military services’ needs. Therefore, they are opposed to the adoption of a

single method of operating name-brand, fast-food restaurants. Even

NEXCOM officials, who use the indirect method to operate most of the

exchange’s fast-food restaurants, said situations exist where the direct

method makes more sense. Neither exchange, however, used a business

case analysis that weighed the factors identified in table 6 with

profitability considerations, which then led to a decision to choose a

particular operating method.

 10 DOD policy for public-private ventures is in Instruction 1015.13, Department of Defense

Procedures for Implementing Public-Private Ventures (PPVs) for Morale, Welfare, and

Recreation (MWR) Category C Revenue-Generating Activities, dated June 17, 1998.
Page 20 GAO-01-683 Defense Management

DOD’s policy on operating name-brand, fast-food restaurants established a

preference for using the indirect method within the continental United

States and the direct method overseas. The exchanges, however, have not

always followed this policy because, in part, DOD has not provided

guidance for evaluating operating methods or criteria for determining

when a deviation from the policy might be justified. In general, each

exchange service has adopted the operating method that it believes best

fits its particular circumstances. While the exchanges may need flexibility

to choose an operating method that best meets their mission requirements,

DOD may be missing opportunities to reduce the exchanges’ operating

risks and increase the amount of funds provided to MWR activities

because DOD’s policy is not clear and department officials have provided

limited management oversight.

In early 1988, when DOD issued its current policy memorandum on namebrand, fast-food operations, its stated goals were to control the

proliferation of fast-food restaurants on military installations, award

business to American investors, and ensure that restaurants on military

installations charged prices that were comparable to those in adjacent

communities. To help achieve these goals, the policy expressed a

“preference” for using the indirect method within the continental United

States and the direct method overseas.11 The policy also stated that the

requirements would be strictly followed and any deviations had to be

approved in writing by the Assistant Secretary (Force Management).

However, the policy memorandum provided no criteria for approving a

deviation. The policy memorandum also stated that construction of

fast-food restaurants would continue to be reviewed as part of the annual

nonappropriated fund construction program.

Officials in the Office of the Assistant Secretary told us that the policy is

still the primary guidance for determining how name-brand, fast-food

restaurants should be operated. They acknowledged that the policy lacks

criteria for determining when a deviation from the policy should be

approved. They also stated that, for the most part, they have not been

actively involved in overseeing how well the exchanges were adhering to

the policy. They pointed out, however, that, in June 1998, the Department

issued a new instruction that bears on this issue. This instruction calls for

 11 DOD’s policy objectives generally relate to U.S. restaurants. Although the policy did not

state a rationale for preferring the direct method overseas, DOD officials told us that there

was a recognition that relying on the private sector to provide fast-food services in other

countries might not be a viable alternative.

DOD’s Policy Lacks

Guidance for

Evaluating Operating

Methods and Criteria

for Approving

Deviations From the

Policy
Page 21 GAO-01-683 Defense Management

the military secretaries and exchange services to consider public-private

ventures as an alternative way of meeting capital requirements when the

requirement exceeds $1 million. Each public-private venture is to be

supported by an economic analysis. In addition, whenever a venture

involves construction financed by the private sector, an overseas fast-food

restaurant, or liabilities to the government in excess of $500,000, it is to be

reviewed by DOD policy officials. These officials pointed out that they

have taken a more active role in overseeing compliance with the

instruction. Thus far, however, the instruction has had minimal application

to the exchange services’ restaurant operations since contracts for most of

these restaurants existed before the instruction was issued. DOD policy

officials’ recent reviews have applied, for the most part, to public-private

ventures associated with the military services’ MWR activities, rather than

the military exchanges. Consequently, it is somewhat unclear if and how

the instruction will affect the Department’s long-standing name-brand,

fast-food policy.

Since name-brand, fast-food restaurants first appeared on military

installations in the 1980s, each exchange has tended to adopt an operating

method that it believes best fits its overall mission objectives, operating

philosophies, and access to capital resources. AAFES, for example, has a

large support infrastructure, access to investment capital, and a long

history of directly operating the majority of its business operations. It

seldom deviates from the direct method, either within the United States or

overseas.12 While this approach appears to be in conflict with DOD’s

preference for using the indirect method in the continental United States,

AAFES officials believe they are following DOD policy and congressional

guidance. In explaining this situation, they noted that both DOD and the

Congress had annually approved construction projects for directly

operated restaurants in the United States. This was, in their view, an

indication that AAFES had the flexibility and approval to deviate from the

policy without asking for a formal waiver. NEXCOM, on the other hand,

does not have a large support infrastructure and prefers not to invest

capital in such restaurants. It has, therefore, adopted the indirect method

of operating its restaurants, even in overseas locations.

 12 AAFES uses the indirect method to operate several name-brand restaurants in the United

States, including three McDonald’s restaurants. AAFES officials told us the indirect method

was selected in these situations to address private sector concerns about AAFES building

and operating restaurants that would compete with or encroach on the business of existing

restaurants in nearby communities.
Page 22 GAO-01-683 Defense Management

While exchange personnel told us that they generally prepared an analysis

prior to building a new restaurant, the analysis focused primarily on what

type and/or size of restaurant would best meet an installation’s

requirements (free-standing or food court) and whether it would be

profitable under the specific circumstances. It did not include an analysis

of the relative benefits—including profitability and other factors such as

those discussed in this report—of the direct and indirect methods of

operating the restaurant. As a result, the exchanges are not conducting the

type of business case analysis that we believe would help them select and

justify the operating method that best balances restaurant profitability

with other factors.

The Department may have missed opportunities to increase profits for

MWR activities because its policy for operating name-brand, fast-food

restaurants has not been clear and policy implementation has not been

subject to consistent management oversight. As a result, the exchange

services have not always had a compelling reason to analyze the financial

and operational benefits of the two operating methods. While our analyses

clearly showed that the indirect method produced greater profitability in

the recent past and has the potential to generate higher profits if new

restaurants are built, other factors can be important when deciding on

which method to use. Nevertheless, the exchanges do not systematically

develop a business case analysis to justify an operating method—an

analysis that considers profitability and other factors before deciding

which operating method to use. To address this situation, DOD needs a

clear policy—one that includes a standard approach or methodology for

selecting a name-brand restaurant’s operating method. A rigorous financial

analysis and consideration of other factors would be part of the

methodology. In addition, the policy needs to specify criteria that will help

DOD evaluate when deviations from any preferred method are justified.

Finally, the policy needs to address how the Department’s new instruction

on public-private ventures bears on its fast-food policy. Having a sound

name-brand, fast-food policy is likely to become increasingly important to

DOD because the exchange services’ contracts with major name-brand

companies will expire in 2004 and the exchanges will have to decide which

method will be used to continue providing name-brand fast food.

To properly weigh profitability and other factors in selecting operating

approaches for name-brand, fast-food operations on military installations,

we are recommending that the Under Secretary of Defense (Personnel and

Readiness), in conjunction with the secretaries of the military services,

revise the Department’s name-brand, fast-food policy by

Conclusion

Recommendation for

Executive Action
Page 23 GAO-01-683 Defense Management

• incorporating a standard methodology that considers both profitability

and other factors to be used by the exchange services to identify the

most appropriate method for operating fast-food restaurants,

• including criteria to approve deviations from any preferred operating

method specified in the revised policy guidance, and

• clarifying how the instruction on public-private ventures affects the

policy.

We also recommend that the exchange service commanders ensure that

the standard methodology is used before they renew a restaurant contract

or open a new restaurant.

In commenting on a draft of this report, the Assistant Secretary of Defense

(Force Management Policy) concurred with its conclusions and

recommendations. The Assistant Secretary stated that the Department

will revise its name-brand, fast-food policy by (1) including a methodology

that evaluates both economic and noneconomic factors when selecting an

operating method, (2) including criteria and procedures for approving

waivers from using the preferred operating method, and (3) clarifying how

its instruction on public-private ventures applies to its policy. DOD

expects to issue updated policy by November 1, 2001. DOD’s comments

are in appendix III.

We are sending copies of this report to the Secretary of Defense; the Under

Secretary of Defense (Personnel and Readiness); the Secretaries of the Air

Force, the Army, and the Navy; the Commander, AAFES; the Commander,

NEXCOM; the Director, Office of Management and Budget; and interested

Agency Comments
Page 24 GAO-01-683 Defense Management

congressional committees and members. We will also make copies

available to others upon request.

If you or your staff have questions concerning this letter, please contact us

on (202) 512-8412. Staff acknowledgments are listed in appendix IV.

Barry W. Holman, Director

Defense Capabilities and Management

Gregory D. Kutz, Director

Financial Management and Assurance
Appendix I: Scope and Methodology

Page 25 GAO-01-683 Defense Management

To develop an understanding of the military exchanges’ name-brand,

fast-food operations, we reviewed the history of these operations in the

Department of Defense (DOD). We met with management officials from

the Office of the Under Secretary of Defense (Personnel and Readiness)

responsible for DOD’s name-brand, fast-food policy and discussed the

Department’s implementation of its policy. We also met with senior

management officials from the Army and the Air Force responsible for

food services that supported morale, welfare, and recreation (MWR)

activities to obtain their views on the direct and indirect methods of

operating fast-food restaurants. We reviewed applicable DOD policies and

regulations, related policy memorandums, and reports related to exchange

service fast-food operations. We met with senior executives and managers

responsible for financial management and food services at the Army and

Air Force Exchange Service (AAFES) and the Navy Exchange Service

Command (NEXCOM) headquarters to discuss fast-food operations and

review documentation, financial reports, internal and external audit

reports, and contract data.

To determine which method of operating name-brand, fast-food

restaurants was more profitable, we obtained and analyzed detailed

financial information from AAFES and NEXCOM for their fiscal year 1998

and 1999 name-brand, hamburger sales; associated costs and expenses;

commissions; and related data. The financial data for these years was the

most current data available at the time of our review. The data involved

primarily Burger King restaurants operated by AAFES and McDonald’s

restaurants operated by either McDonald’s Corporation or its licensed

operators (also called concessionaires) under NEXCOM’s purview.

Because hamburger sales represented over 50 percent of the exchanges’

name-brand, fast-food sales for these years, we primarily analyzed

hamburger restaurants, which represented the largest segment of

name-brand, fast-food sales and therefore provided a sound basis for

comparing the direct and indirect methods of operation.

We analyzed the overall profitability of the restaurants operated under

each method. For the direct method, net profit represented a restaurant’s

total revenues less its operating costs and overhead costs. Economic

earnings represented net profit less the opportunity cost associated with

invested capital—this is also known as the cost of capital. For the indirect

method, net profit and economic earnings represented the revenues—

comprised of sales commissions, signing bonuses, and licensing fees—

received from the name-brand company less overhead costs. Operating

costs and the cost of capital were not applicable to the indirect method.

Besides assessing overall profitability, we also analyzed profitability by

Appendix I: Scope and Methodology
Appendix I: Scope and Methodology

Page 26 GAO-01-683 Defense Management

sales volume, restaurant type (free-standing and food court), and general

location (continental United States or overseas) to isolate unique

conditions that might exist under one of the methods of operation. In this

report, our use of the terms “profit” or “profitability” refers to economic

earnings for the direct method of operation and net profit for the indirect

method of operation, which are expressed as a percentage of restaurant

sales.

To determine if the exchange services considered all of the costs of their

name-brand, fast-food operations, we reviewed financial reports, general

ledger balances, and other data provided to us by each exchange service.

However, we did not verify the accuracy and reliability of the data

submitted to us by AAFES and NEXCOM management and express no

opinion on its reliability. Both exchanges are audited annually by

independent public accountants. For the fiscal years we reviewed (1998

and 1999), NEXCOM received an unqualified opinion and AAFES received

an “except for” qualified opinion on their financial statements.1 We read

the audit opinions for each exchange service to determine if there were

any material weaknesses that came to the auditors’ attention that would

indicate the financial data were unreliable. Except for AAFES not

recording the cost of a defined benefit pension plan in accordance with

Statement on Financial Accounting Standard No. 87, Employer’s

Accounting for Pensions, material weaknesses were not reported by the

exchange services’ independent public accountants. We discussed this

issue with AAFES management and concluded that it did not have a

bearing on the financial data we used in our analysis.

To determine the reasonableness of the exchanges’ overhead rates, we

reviewed the methodologies the exchange services used to capture and

allocate overhead costs. We met with management and internal audit

representatives of each exchange service to review steps they had taken to

validate the methodologies and costs included in the overhead rates. We

also compared the exchange services’ overhead rates to rates reported by

leading name-brand, food service companies in their annual financial

reports. NEXCOM developed its overhead rate after we inquired about

overhead costs related to name-brand fast foods. AAFES had

corporatewide overhead rates of 4.9 and 5.1 percent of sales for 1998 and

 1

 In general, the fiscal year for the exchange services covers the period from February 1st

of a given year to January 31st of the following year. This period is consistent with the

fiscal year used by the retail industry.
Appendix I: Scope and Methodology

Page 27 GAO-01-683 Defense Management

1999, respectively, which we used in our financial analysis. Before using

them, however, we met with AAFES financial management and food

service officials to determine if the exchange service had or could develop

a rate for food operations in general or for restaurants operating under the

direct method. AAFES officials told us they were unable to develop an

overhead rate for food operations. Subsequent to completing our work at

AAFES, representatives of AAFES informed us they had developed new

overhead rates specifically for name-brand, hamburger restaurants

operating under the direct method. The rates were 3.3 percent for both

fiscal years 1998 and 1999. We discussed the approach AAFES used to

develop these rates. We also compared AAFES’ new overhead rates with

the rates of eight food service companies that included a range of

name-brand companies. All of the companies were included in Fortune

Magazine’s list of top 10 food service companies based on revenues. We

obtained these food service companies’ overhead rates from their

published financial statements. This comparison showed that AAFES’ new

rates of 3.3 percent were substantially lower than those used by the food

service companies included in our analysis. Rates for these companies

ranged from 3.8 percent to 11.8 percent, with the mid-range rate being

about 6.3 percent. Based on the results of this comparison, we did not use

AAFES’ new rates in our detailed analysis shown in table 1. However, if we

had used the new rates, AAFES’ profitability as a percentage of sales

would increase from 7.8 percent to 9.4 percent in fiscal year 1998, and

from 5.5 percent to 7.3 percent in fiscal year 1999 – still less profitable than

the indirect method.

The cost of capital applies to AAFES because, under the direct method, it

builds and equips its restaurants. When making a decision to build and

operate a restaurant, an exchange needs to evaluate the costs of initial

construction, initial equipment and fixtures, and subsequent scheduled

renovations (to the extent they are known). These costs, generally referred

to as capital costs, are usually paid for by AAFES through borrowing or

through cash that is available from its profits. Also, other potential uses of

the capital should be considered in the evaluation to ensure that

committing capital to building the restaurant is a sound and defensible

financial decision. These costs may include implicit costs, such as

opportunity costs, that would not appear on an entity’s financial

statements but should be considered when evaluating profitability and

making capital investment decisions. The ability of a restaurant to recover

these costs will depend on the expected profitability of the restaurant as

well as financial and operational risks associated with the restaurant’s

operations. Some companies and organizations, such as AAFES, establish
Appendix I: Scope and Methodology

Page 28 GAO-01-683 Defense Management

a cost of capital rate, normally expressed as a percentage, to evaluate their

existing and planned capital projects.

AAFES used a 10-percent cost of capital during both fiscal years 1998 and

1999 and applied this rate to capital investment decisions. In other words,

AAFES expects to earn at least 10 percent on its capital investments. With

respect to assessing profits from its fast-food operations, AAFES also

applied this rate to the average cost of its supply inventories and the

undepreciated value (net book value) of its buildings, equipment, and

subsequent improvements and replacements. In our profitability analysis,

we applied a cost of capital charge to net profits to determine economic

earnings. Our method of calculating the cost of capital charge was

consistent with the method AAFES used.

To test the reasonableness of AAFES’ 10-percent cost of capital rate, we

calculated a cost of capital number that could apply to a private sector

company in the food services industry. We used a standard approach, a

weighted average cost of capital, found in corporate finance text books to

calculate a cost of capital that would be appropriate for firms in the

name-brand, hamburger industry. We also used financial data from Value

Line Publishing for two major food service corporations, McDonald’s and

Wendy’s, to make our calculation.2

 Because the financial situation of every

business entity will be different, we did not expect our calculation to

produce the same rate that AAFES used, but we did want to assure

ourselves that AAFES’ reported cost of capital was reasonable for firms in

the fast-food, hamburger business. The cost of capital rate we calculated

was close enough to AAFES’ to assure ourselves that it was appropriate to

use it in our calculation.

We also conducted a 20-year, net present value analysis of future cash

flows for a capital investment in a new name-brand, fast-food hamburger

restaurant for both methods. Our analysis was based on fiscal year 1998

and 1999 sales and cost data provided by the exchange services. We

applied an investment planning tool, called net present value, which

measures both the magnitude and timing of projected cash flows and

discounts the expected annual cash flows by applying the time value of

money to reflect their value today. As a result, the analysis shows, in

today’s dollars, the financial return that an investment in such a restaurant

 2

 We did not use financial data for Burger King because a European firm whose primary

business is wine and spirits owns Burger King.
Appendix I: Scope and Methodology

Page 29 GAO-01-683 Defense Management

operated under each method is expected to contribute to an exchange

service’s profits. We chose 20 years because this is generally the useful life

of the facilities and equipment. We calculated a per restaurant average for

sales and cost of operations. For the direct method, we added depreciation

expenses to net profit to arrive at the annual positive cash flow. We

included depreciation in the cash flow because, although it is an expense

that is considered in arriving at net income, it does not represent an outlay

of cash. The net present value technique also calls for depreciation to be

included in the cash flows. We used initial construction and equipment

costs provided by AAFES. The required incremental capital investments

were based on historical data also provided to us by AAFES.

We conducted several analyses using the net present value technique.

First, we combined the fiscal year 1998 and 1999 sales data obtained from

each exchange service and calculated per restaurant average sales over

the 2-year period. This analysis is presented in the body of the report. We

also conducted several other analyses. They included analyses of (1) fiscal

year 1998 data, (2) fiscal year 1999 data, and (3) a pro forma analysis that

used equivalent sales for each exchange. The pro forma analysis was

intended to neutralize the difference in sales volumes of AAFES and

NEXCOM.

Our analysis was also based on a number of assumptions. For example, we

assumed that combining or averaging 1998 and 1999 financial data would

be representative of sales and costs for each year in the 20-year period. We

also used a facilities and equipment renovation cycle of every 5 years,

which is consistent with the information provided by AAFES and

NEXCOM. For each method, we analyzed free-standing and food court

restaurants separately because of significant differences in their capital

costs, sales volumes, and cash flows.

The discount rate we used to calculate the net present value figures was

based on AAFES’ cost of capital, which was 10 percent. We needed to use

a real cost of capital so we adjusted AFFES’ cost of capital by subtracting

projected future inflation to derive a real cost of capital. We used the

March 2001 Blue Chip Economic Indicators, which are averages of the

projections of many major economic forecasters, to derive a long-term

inflation forecast of the Consumer Price Index (for all urban consumers).

The long-range forecast was about 2.5 percent. The Congressional Budget

Office and the Office of Management and Budget were also forecasting

around 2.5 percent in their latest long-range projections for this price

index. We subtracted the long-term inflation forecast of 2.5 percent from
Appendix I: Scope and Methodology

Page 30 GAO-01-683 Defense Management

AFFES’ 10 percent cost of capital to derive a real cost of capital of 7.5

percent, which we used in our cash flow analysis.

We also did a sensitivity analysis for the inflation forecast with two other

scenarios to see if this would change our results. We assumed the

inflation rate could be as low as 2 percent and as high as 3 percent, which

would change the real cost of capital to 8 percent and 7 percent,

respectively. Under these two scenarios, our conclusions did not change.

We also projected the results beyond 20 years to determine when AAFES’

total net cash flows for a new name-brand, hamburger restaurant would

break-even with and begin to exceed NEXCOM’s. We knew this might

eventually happen because AAFES’ annual net cash flows exceeded

NEXCOM’s, except in the years that involved additional capital investment

for required renovations. This analysis showed that, before the annual net

cash flows were discounted, AAFES’ cash flows would not begin to

exceed NEXCOM’s until after the 35th year of operation for a food court

restaurant and after the 80th year for a free-standing restaurant. If the cash

flows were discounted, it would take longer for AAFES’ net cash flows to

exceed NEXCOM’s.

To determine if a single method of operating name-brand, fast-food

restaurants would be more beneficial to DOD when factors other than

profitability were considered, we obtained documentation related to this

issue from the exchange services. We also interviewed officials in the

Office of the Under Secretary of Defense (Personnel and Readiness) and

exchange service representatives to obtain their views on this subject. We

categorized DOD officials’ written and oral responses under the general

topics of financial risk, customer service, employment opportunities,

management control, operational risk, and investment opportunities.

We also met with officials of the Marine Corps Community Services office,

which manages all MWR activities for the Marine Corps, to obtain their

views on name-brand, fast-food operations. We also obtained

documentation related to the number of fast-food restaurants located on

Marine Corps installations and their sales and costs for fiscal years 1998

and 1999. Although we limited our analysis to AAFES and NEXCOM, we

did use some of the Marine Corps data in the background section of this

report.

Our methodology has some limitations. First, the financial analysis was

based on historical data that may or may not represent future market

conditions, operating efficiencies, or the way name-brand, fast-food

operations will be carried out in the future. Second, our analysis did not
Appendix I: Scope and Methodology

Page 31 GAO-01-683 Defense Management

assess the overall tax implications of using the direct and indirect

methods. Presumably, the indirect method would provide tax revenues to

the government because concessionaires’ profits are subject to federal

taxes and the direct method would also provide some tax revenues

because royalties paid by an exchange service to the franchiser would also

be taxable. Lastly, our financial analysis considered only one food

concept, hamburgers, and may not be appropriate to other food concepts

such as chicken and pizza.

Our work was performed at the Office of Force Management Policy,

Undersecretary of Defense (Personnel and Readiness) in Washington,

D.C.; AAFES headquarters in Dallas, Texas; NEXCOM headquarters in

Virginia Beach, Virginia; the Food and Hospitality Branch, Marine Corps

Community Services, United States Marine Corps at Quantico, Virginia; the

Army Community and Family Support Center in Alexandria, Virginia; and

the Air Force Combat Support and Community Services Office, in

Washington, D.C. We also met with representatives of the Burger King

Corporation located in Miami, Florida, and McDonald’s Corporation

located in Oak Brook, Illinois. We performed our work from September

2000 through May 2001 in accordance with generally accepted government

auditing standards.
Appendix II: Fiscal Year 1999 Inventory of

AAFES and NEXCOM Fast-Food Restaurants

Page 32 GAO-01-683 Defense Management

AAFES NEXCOM

Direct Facilities Sales Facilities Sales

Name-brand, fast-food 324 $249,064,463 27 $3,689,329

Other food 993 $214,515,148 161 $35,654,669

Deactivated food facilitiesa 92 $5,700,379 b

Total direct 1,409 $469,279,989 188 $39,343,998

Indirect

Name-brand, fast-food 29 $19,016,589 193 $92,257,892

Other food 284 $24,134,321 53 $22,007,643

Total indirect 313 $43,150,910 246 $114,265,534

Total food 1,722 $512,430,899 434 $153,609,532

a

During fiscal year 1999, AAFES closed or deactivated 92 restaurants. The sales for these

restaurants are shown as a separate total.

b

Data was not available from NEXCOM. NEXCOM officials told us that this number is likely

insignificant.

Source: AAFES and NEXCOM fast-food financial and inventory data.

Appendix II: Fiscal Year 1999 Inventory of

AAFES and NEXCOM Fast-Food Restaurants
Appendix III: Comments From the Department of Defense

Page 33 GAO-01-683 Defense Management

Appendix III: Comments From the

Department of Defense
Appendix III: Comments From the Department of Defense

Page 34 GAO-01-683 Defense Management
Appendix III: Comments From the Department of Defense

Page 35 GAO-01-683 Defense Management
Appendix IV: Staff Acknowledgments

Page 36 GAO-01-683 Defense Management

Cherry Clipper, Eric Essig, Cleggett Funkhouser, James Fuquay, James

Hatcher, Charles Perdue, Bob Preston, Jerry Thompson, and John Van

Schaik made key contributions to this report.

Appendix IV: Staff Acknowledgments

Acknowledgments
Glossary

Page 37 GAO-01-683 Defense Management

This glossary is provided for reader convenience in understanding terms

as they are used and applied in this report, not as authoritative or

complete definitions.

A percentage paid on gross sales either as a flat percentage rate or a

graduated rate based on sales brackets identified in the contract between

the exchange and the franchise.

A food service provided under contract to provide any segment of food

service, either branded or non-branded, at a given installation in a

permanent structure or temporary unit (i.e., mobile unit or kiosk).

The opportunity cost (or economic cost) associated with alternative uses

for invested capital of comparable risk. Includes funds invested in

buildings, equipment (including periodic renovations and upgrades) and

inventory.

The operation of either non-branded or branded food service staffed by an

exchange service’s direct hire associates. The exchange is responsible for

providing/building and maintaining its own facilities, inventory,

equipment, utilities, financial records, and personnel.

Method of measuring the cash inflows and outflows of a capital

investment or project as if the flows occurred at a single point in time so

that they can be appropriately compared. Because the method considers

the time value of money, it is usually the best method to use for evaluating

long-term investment decisions.

Net profit less the opportunity cost, also referred to as the cost of capital,

associated with invested capital.

A restaurant chain, either nationally or regionally recognized, providing a

standardized system of policies, procedures, marketing/advertising

schemes, logos, trademark, source of supply, source of equipment, and

access to the franchise contracts.

The operation of either non-branded or branded food service by a

concessionaire or third-party contractor via a contract with an exchange

service.

A term for the legally binding agreement between a franchisee and a

franchiser.

Glossary

Commissions

Concession

Cost of capital

Directly operated

Discounted cash flow

Economic earnings

Franchise

Indirectly operated

License agreement
Glossary

Page 38 GAO-01-683 Defense Management

An amount, usually paid on a per site basis, for the right to operate a

concession at awarded site(s). The fee is remitted to the exchange service

prior to the sites’ or facilities’ availability/operational date.

Refers to a food service concept that is national (more than 10 states),

regional (less than 10 states), or in-house (operated only with a given

company’s units).

A nationally recognized fast-food restaurant chain that operates in more

than 10 states.

The dollars that are left after sales or revenues have offset expenses. The

dollars can be expressed at current value or at a discounted value, if the

time value of money is considered.

A discounted cash flow technique that calculates the expected net

monetary gain or loss from a project by discounting all expected future

cash inflows and outflows to the present point in time, using a specified

rate of return.

Total sales/revenues less operating costs and overhead costs.

The cost of goods sold and operating expenses, including depreciation.

Refers to economic earnings for the direct method of operation or net

profit for the indirect method of operation and is expressed as a

percentage of restaurant sales. Under the direct method, profitability

represents a restaurant’s total revenues less its operating costs, overhead

costs, and the opportunity costs associated with invested capital (the cost

of capital). Under the indirect method, profitability represents the

revenues (sales commissions, signing bonuses, and licensing fees)

received from the name-brand company less the exchange service’s

overhead costs.

An agreement between a DOD nonappropriated fund activity, such as an

exchange service, and a non-federal entity under which the non-federal

entity provides goods, services, or facilities to authorized MWR activities

and exchange patrons. The non-federal entity may provide a portion or all

of the financing, design, construction, equipment, and staffing associated

with the activity.

Licensing fee

Name-brand

Name-brand, fast-food

Net cash flow

Net present value

Net profit

Operating costs

Profitability

Public-private venture
Glossary

Page 39 GAO-01-683 Defense Management

Under the direct method, revenue includes restaurant sales plus other

income. Other income is primarily the proceeds from selling surplus

equipment and additional revenue realized in overseas locations from

foreign currency conversions at the point of sale. Revenues under the

indirect method are sales commissions based on restaurant sales plus

licensing fees and signing bonuses.

Gross restaurant or food sales less all applicable taxes and coupon

redemptions recorded at the point of sale.

A lump sum payment made to an exchange service by a concessionaire or

a third-party contractor at the time a contract is signed.

Revenues

Sales

Signing bonus

(709550)

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