Defense Industry: Restructuring Costs Paid, Savings Realized, and Means to Ensure Benefits
Released: 1998-12-01T00:00:00

Letter

Background

To encourage defense contractor consolidations, DOD announced in July 1993 that it would pay for restructuring costs on transferred flexibly priced contracts, provided that (1) the restructuring costs were allowable under the Federal Acquisition Regulation and (2) a DOD contracting officer determined that the business combination was expected to result in overall reduced costs to DOD or preserve a critical defense capability. Concerns over the payment of restructuring costs led Congress in 1994 to pass Public Law 103-337, which required a senior DOD official to certify that projections of restructuring savings were based on audited cost data and that the projected savings should result in overall reduced costs to DOD.

In 1996, Congress passed Public Law 104-208, which stipulated that for business combinations occurring after September 30, 1996, projected savings had to (1) be at least twice the amount of costs allowed or (2) exceed the costs allowed, provided the Secretary of Defense determined that the combination would result in the preservation of a critical capability. Public Law 105-85 made these requirements permanent. None of the combinations discussed in this report were subject to the two-to-one ratio requirement because they occurred before this requirement was established. The Secretary of Defense is required to report to Congress annually through 2002 on DOD’s experience with defense contractor business combinations occurring on or after August 15, 1994.

Restructuring Savings and Costs

In April 1998, we reported that, for the seven business combinations, DOD expects to save a net of almost $3.3 billion between 1993 and 2000 from restructuring activities, such as laying off workers, closing facilities, and relocating employees and equipment. Table 1 shows DOD’s projection of its share of restructuring savings and costs for these business combinations.

We reported in September 1998 that our work had shown that selected restructuring activities at 10 contractor business segments had enabled the contractors to reduce their projected operating costs by hundreds of millions of dollars. These reductions benefited DOD because defense contracts’ costs were lower than they would have been if the restructuring activities had not occurred. However, not all of the restructuring savings shown in table 1 may be directly attributable to restructuring.

We noted in our April 1998 report that Lockheed Martin had projected about $489 million of restructuring savings from increased operational efficiencies at its Missiles & Space segment by adopting improved business practices. Contractor officials acknowledged that some of the improvements and associated savings could have been implemented without restructuring because various efforts were already underway or planned to improve the segment’s operational efficiency prior to restructuring. However, these officials believed that the business combination provided the means to overcome organizational and cultural barriers that might otherwise have hindered these efforts.

Subsequently, we reported in September 1998 that Lockheed Martin did not fully consider the impact of normal downsizing activities when estimating restructuring savings. For example, Lockheed Martin attributed 1,153 support personnel reductions at its Missiles & Space segment in 1995 to restructuring activities. However, before its merger with Martin Marietta, Lockheed had forecasted that its total personnel level at this segment would decrease by 849 in 1995. Because Lockheed Martin did not consider reductions that were already planned, the amount of savings that was directly attributed to restructuring for 1995 may be overstated by $170 million.

While our work raised questions as to whether all of the projected savings are directly related to restructuring, these two overstatements would not have affected DOD’s decision to pay restructuring costs because of the large amount of projected savings from the Lockheed - Martin Marietta business combination.

We reported in April 1998 that DOD estimated it had realized a net savings of about $1.9 billion from the seven business combinations. Now, DOD estimates it has realized a net savings of about $2.1 billion (see table 2). The estimated savings realized represent about 64 percent of the restructuring savings expected at the time of certification.

We commented in the April 1998 report that caution should be exercised when interpreting DOD’s reported restructuring savings. We noted that the savings DOD reported were generally not developed from a detailed analysis of the effect of restructuring on individual contract prices but rather were estimated using the same or similar methodologies employed to estimate savings during the certification process. DOD has consistently stated that it is inherently difficult to precisely identify the amount of actual savings realized from restructuring activities.

Methodology for Determining Savings on Specific Contracts Not Feasible

It is not feasible to develop and apply a standard methodology that can be used to separate the precise impact of restructuring from the impact that other factors have on contract prices. Determining the precise impact that restructuring activities have on a contract price requires isolating the effect of restructuring from nonrestructuring-related factors. In its annual reports to Congress, DOD has stated that factors such as inflation, business fluctuations, accounting system changes, quantities purchased, and subsequent reorganizations, affect a contractor’s overall cost of operations. DOD noted that it is not feasible to precisely isolate the impact of restructuring from the impact of these other factors. As previously reported, our work substantiates DOD’s position.

During our work for the September 1998 report, the contractors we visited provided several examples that they believed demonstrated how specific contract prices were affected by restructuring. For example, Martin Marietta provided information showing that the Navy purchased 25 test equipment items at a unit price of $1,270,524 before its acquisition of the General Electric business segments and 25 of the same test equipment items at a unit price of $1,246,230 after the acquisition and subsequent restructuring. Even though the unit price was $24,294 lower after restructuring, neither we nor contractor officials could isolate the impact of restructuring from the influence of other factors, such as learning curve improvement and business base changes. Contractor officials believe the unit price reduction was attributable, in part, to restructuring activities but acknowledged that the other factors also affected the unit price.

A similar problem existed with the other examples provided by the contractors. Neither we nor the contractors could separate the effect of restructuring from the influence of other factors that also affected the contract prices. Speaking on behalf of business combinations included in our September 1998 report, the Aerospace Industries Association noted that it was not practical to determine the impact of restructuring on contract prices because so many variables affect prices.

Other Means to Ensure DOD Receives Restructuring Benefits

While it is not feasible to develop a methodology to precisely determine the impact of restructuring on contract prices, our work has shown that there are other ways to ensure that DOD receives benefits from restructuring activities. In particular, prompt adjustments of forward pricing rates and the use of reopener clauses would enable DOD to share in the benefits of restructuring in an equitable and timely manner.

Before DOD can benefit from restructuring activities, restructuring savings must be incorporated into a contractor’s forward pricing rates used to price defense contracts. DOD’s acquisition regulations stipulate that its contracting officers should adjust a contractor’s forward pricing rates as soon as practical upon receipt of a restructuring proposal. In commenting on our April 1998 report, DOD highlighted this requirement by stating that, in reviewing contractor restructuring proposals associated with business combinations, one of its major concerns is that restructuring costs and savings are factored into forward pricing rates as soon as possible so that the net savings are priced into new contracts. We strongly agree with DOD’s position. It is imperative that contracting officers adjust the forward pricing rates as soon as possible after a contractor quantifies its estimated restructuring savings so that the lower rates can be used to price contracts.

Before forward pricing rates are adjusted and used to price contracts, contracting officers should incorporate reopener clauses in noncompetitive fixed-price contracts to enable DOD to recoup its equitable share of savings under these contracts. We reported in July 1998 that it took an average of about 21 months from the announcement of a business combination to the time that contractors reflected restructuring savings in forward pricing rates. During that time, DOD awarded over 600 fixed-price contracts or contract modifications worth about $3.9 billion to these contractors. Despite repeated recommendations from the Defense Contract Audit Agency (DCAA) and the Defense Contract Management Command (DCMC), contracting officers rarely included reopener clauses for savings in fixed-price contracts awarded during this period.

The use of reopener clauses has resulted in recouping restructuring savings. In our September 1998 report, for example, we discussed a case where the contracting officer had included a reopener clause in a fixed-price foreign military sales contract for self-propelled howitzers awarded to UDLP, which required UDLP to reduce the contract price after restructuring its operations. Using a proposal developed by UDLP showing the impact of restructuring on the contract, the contracting officer negotiated a $1.8-million reduction to the contract’s $48.5-million price. The $1.8 million could not have been recovered from this fixed-price contract had the reopener clause not been included in the contract at the time it was awarded.

We reported in July 1998 that DOD contracting officers and contractors were reluctant to use reopener clauses. We, therefore, recommended that the Secretary of Defense revise DOD’s regulations to require that contracting officers include the clauses in noncompetitive fixed-price contracts negotiated before the benefits of restructuring savings were reflected in forward pricing rates. We also recommended that, if the clauses were not included, contracting officers provide a written justification in the negotiation records as to why they were not needed.

In responding to our recommendations, DOD agreed to add a new provision to its regulations requiring contracting officers to consider using a reopener clause. DOD did not believe, however, that the use of reopener clauses should be mandatory. DOD stated that contracting officers must be permitted to exercise professional judgment to decide when the clause is appropriate. DOD further stated that documenting the reason for not using a reopener clause would result in an unnecessary administrative burden and was contrary to the principles of acquisition reform.

DOD’s action to add a new provision to its regulations requiring contracting officers to consider using reopener clauses is a step in the right direction. However, we continue to believe that contracting officers should be required to document in the negotiation records the reason they did not include a reopener clause in noncompetitive fixed-price contracts.

Conclusions

While our work has shown that DOD is benefiting from defense contractor restructuring activities, it is not feasible to develop a standard methodology for precisely determining the impact of these benefits on specific contract prices. However, DOD could ensure that it receives its equitable share of restructuring savings in a timely manner by having its contracting officers (1) adjust forward pricing rates as soon as possible to reflect restructuring savings and (2) include reopener clauses in noncompetitive fixed-price contracts awarded before the forward pricing rates are adjusted. DOD has agreed to revise its regulations to require contracting officers to consider the use of reopener clauses.

Agency Comments

DOD concurred with the report’s findings. DOD’s comments are included as appendix I.

Scope and Methodology

In responding to the legislative requirement, we primarily relied on our prior work on defense contractor restructuring activities. As part of our prior work, we reviewed information prepared during DOD’s certification process, including the contractor’s restructuring proposal, DCAA audit reports, negotiation memorandums, and other pertinent information to determine the amount of restructuring savings and costs expected for each of these business combinations. To determine the amount of restructuring costs paid and estimated savings realized, we reviewed DOD’s November 1997 and March 1998 reports to Congress on defense industry restructuring.

To determine the feasibility of developing a methodology for assessing restructuring savings on individual contract prices, we reviewed restructuring activities at 10 contractor business segments, including at least 1 segment from each of the 7 business combinations. We generally selected those business segments with the largest projected amount of restructuring savings. In assessing whether restructuring savings could be traced to contract prices, we tried to compare the overhead rates that were in effect before restructuring with the rates that were in effect after restructuring. We also examined contract-related documents to determine if direct costs were less than before restructuring.

Also, we requested that contractor officials identify comparable items that DOD purchased before and after restructuring. We accepted the items the contractors identified and did not make an independent evaluation to determine whether they identified all available comparable items. We compared the prices DOD paid for these items before and after restructuring to determine if the prices had been affected by restructuring and other factors. In addition, we determined whether contracting officers had included downward-only reopener clauses in fixed-price contracts negotiated before the contractors had adjusted their forward pricing rates to reflect the impact of restructuring. For those contracts containing such clauses, we determined whether contracting officers had exercised the clauses and, if so, the amounts by which the contracts’ prices were reduced.

We discussed the results of our analyses with officials from the business combinations, DOD, DCMC, and DCAA. We performed work in September 1998 to update some of the information included in our prior reports. The work was carried out in accordance with generally accepted government auditing standards.

We are sending copies of this report to the Secretary of Defense; the Commander, DCMC; the Director, DCAA; and the Director, Office of Management and Budget. Copies will also be made available to others upon request.

Please contact me at (202) 512-4841 if you or your staff have any questions concerning this report. Major contributors to this report are listed in appendix II.

Comments From the Department of Defense

Major Contributors to This Report

National Security and International Affairs Division, Washington, D.C.

Atlanta Field Office

Related GAO Products

Defense Contractor Restructuring: Benefits to DOD and Contractors (GAO/NSIAD-98-225, Sept. 10, 1998).

Defense Contractor Restructuring: DOD Risks Forfeiting Savings on Fixed-Price Contracts (GAO/NSIAD-98-162, July 17, 1998).

Defense Industry Restructuring: Updated Cost and Savings Information (GAO/NSIAD-98-156, Apr. 30, 1998).

Defense Industry Restructuring: Clarification of Cost and Savings Issues (GAO/NSIAD-97-186R, June 17, 1997).

Defense Industry Restructuring: Cost and Savings Issues (GAO/T-NSIAD-97-141, Apr. 15, 1997).

Defense Restructuring Costs: Information Pertaining to Five Business Combinations (GAO/NSIAD-97-97, Apr. 1, 1997).

Defense Restructuring Costs: Projected and Actual Savings From Martin Marietta Acquisition of GE Aerospace (GAO/NSIAD-96-191, Sept. 5, 1996).

Defense Contractor Restructuring: First Application of Cost and Savings Regulations (GAO/NSIAD-96-80, Apr. 10, 1996).

Defense Restructuring Costs: Payment Regulations Are Inconsistent With Legislation (GAO/NSIAD-95-106, Aug. 10, 1995).

Overhead Costs: Defense Industry Initiatives to Control Overhead Rates (GAO/NSIAD-95-115, May 3, 1995).

Defense Downsizing: Selected Contractor Business Unit Reactions (GAO/NSIAD-95-114, May 3, 1995).

Defense Industry Consolidation: Issues Related to Acquisition and Merger Restructuring Costs (GAO/T-NSIAD-94-247, July 27, 1994).

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