DOD inventory control points are responsible for managing insurance items. We performed our review at the Aviation Supply Office (ASO), one of two Navy inventory control points, and the Defense Industrial Supply Center (DISC), one of six DLA inventory control points. As of March 1994, ASO managed insurance inventories valued at $193 million and, as of April 1994, DISC managed insurance inventories valued at $3 million. Spare parts and other supplies normally are designated as insurance items during the initial provisioning process. Initial provisioning is designed to provide parts until there is a requisitioning history from which relatively accurate forecasts of future demands can be made. Typically, these parts support a weapon system during the first 2 years of operation. At ASO, contractors or manufacturers recommend which parts should be stocked for insurance purposes, ASO reviews these recommendations, and the Naval Air Systems Command approves the recommendations if it agrees with the contractor and ASO. DISC classifies items on the basis of submissions by the using military service during the initial provisioning process. We analyzed ASO and DISC records to identify insurance items and determine if they were properly classified. We found that most of the items were not mission essential and, therefore, should not have been classified as insurance items. Table 1 summarizes the results of our analysis. Because only a small percentage of the insurance items were fully justified in the inventory control point records, we asked item managers to verify the classification of the insurance items. We randomly sampled 329 ASO items and 110 DISC items and sent questionnaires to item managers asking them to validate the records. According to the ASO item managers surveyed, 51 percent of the items were not mission essential. Table 2 summarizes the sample results. We did not make a similar analysis for DISC because none of the item managers had responded to the questionnaire at the time our fieldwork was completed. Significant numbers of nonessential parts and supplies continue to be stocked as insurance items because ASO and DISC do not have the internal controls to periodically review insurance items to identify those that are unneeded because they do not meet essentiality criteria. As noted in tables 1 and 2, only 10.5 percent of ASO’s insurance items were mission essential according to ASO records and only 22 percent were mission essential according to item manager responses to our questionnaire. At DISC, 42.3 percent were mission essential according to its records. ASO assigns mission essentiality codes on the basis of reports from end users on how the failure of a part affects mission capability. These codes range from one where item failure results in minor mission impact to one where item failure results in loss of a primary mission capability. DISC assigns essentiality codes, called weapon system indicator codes, on the basis of data provided by the using military service. Neither ASO nor DISC systematically reviews insurance items to validate the essentiality codes. ASO does require an annual review to ensure that the data elements used to prevent automatic purchases of insurance items are correctly loaded in the computer. However, this review does not verify that insurance items are mission essential. DISC does not require a review of insurance item essentiality. The absence of essentiality reviews contributed significantly to the low percentage of mission essential items identified in our review. In addition to the 22 percent ASO item managers said were mission essential, they indicated that 51 percent of the insurance items were not mission essential and that they either could not or did not determine essentiality for the remaining 27 percent. The following examples illustrate the error conditions identified. ASO stocks three skin assembly units used on the AV-8B aircraft as insurance items. These units, which are valued at a total of $158,927, have a nonessential coding in ASO’s records. In responding to our questionnaire, the item manager agreed with the coding in the record and indicated that the units were not mission essential. These assemblies have been in the Navy supply system since the weapon system was provisioned in 1986. In another case, ASO stocks 12 manual control levers used on the F/A-18 aircraft as insurance items. These levers, which are valued at a total of $997,020, have been in the supply system since 1983. Again, the item manager indicated that the lever, although categorized as an insurance item in the records, was not mission essential. Although DOD Material Management Regulation 4140.1-R, dated January 1993, states that only one replacement unit of an item may be stocked for insurance purposes, we found that ASO and DISC stocked many of the insurance items in quantities greater than one unit. This condition was true for both mission essential items and nonessential items. At ASO, 4,997 insurance items, valued at $126 million, or 50 percent, of the 9,937 insurance items were stocked in quantities greater than one unit. Of the 1,042 mission essential items included in these totals, 510 items had excessive quantities valued at $49 million. At DISC, 1,602, or 48 percent, of the 3,335 insurance items were stocked in quantities greater than one unit, including 784 of 1,410 mission essential items. The reasons for the excessive quantities are similar to the reasons that nonessential items are stocked as insurance items. That is, much of the excessive buildup occurred during the initial provisioning process. DOD downsizing and weapon system obsolescence and retirement also contributed to the stock buildup. However, neither ASO nor DISC has established the internal controls to periodically review insurance items to ensure that quantities are kept at the allowable stock level of one unit. An additional factor contributing to the excessive quantities is the inventory control points’ stock retention policies. ASO and DISC have computer programs to identify and recommend excess stock for disposal. ASO programs search for stocks in excess of retention levels and are run for all stocked items, not just insurance items. However, irrespective of retention levels, the programs will not recommend disposal action on quantities that fall below a floor of five units at ASO. The DISC programs identify disposal prospects on a selective basis and have not been run for insurance items. The computer programs have not been effective in reducing excess insurance stocks at ASO for two major reasons. First, contrary to DOD regulations, ASO has established retention levels for many insurance items that exceed the allowed stockage quantity of one unit. Second, the requirement that any disposal recommendation leave an on-hand quantity of five units precludes reducing the stockage level to one unit. As a result, only 330 of the 4,997 insurance items that we found to be overstocked were identified as such by ASO’s computer program. The following examples illustrate the overstockage conditions identified. ASO stocks 20 aircraft seat structures used on the A-7 aircraft as insurance items. These structures, which are valued at a total of $2,559,586, have been in the supply system since 1979. In responding to our questionnaire, the item manager indicated that 14 of these units were removed from aircraft as a result of design changes and were unserviceable. The remaining six units were serviceable but exceeded the allowed insurance stock level of one unit. In another case, ASO stocks two electrical equipment racks used on the E-2C aircraft as insurance items. These racks, which are valued at a total of $687,480, exceed the allowed insurance stock level of one unit but will not be reviewed for potential disposal because the quantity falls below ASO’s on-hand stockage floor of five units. The item manager agreed that the racks were in an excess position but would not recommend this item for disposal because of the on-hand stockage floor. In addition to unneeded procurement costs, DOD incurs large costs to manage and maintain excess inventories, particularly items with low demand or years of supply on hand. DOD expresses these holding costs as a percentage of the value of on-hand inventory. Holding costs include investment cost, or the cost of having funds tied up in inventory; storage costs; and obsolescence costs. The holding cost rate varies by inventory control point and averages 22 percent at ASO and 18 percent at DISC. In commenting on our draft report, DOD stated that the holding cost rates we used may be correct before a purchase decision is made, but once material is in inventory the risk of obsolescence is represented as a sunk cost and the opportunity to spend the funds on an alternative investment has been foregone. DOD also stated that the holding cost rates that should have been applied for material in stock is at least an order of magnitude less than the rates used in the report. DOD did not give an alternative percentage or amount and DOD’s accounting systems are not designed to capture actual holding costs. In commenting on another report (GAO/NSIAD-94-110, June 29, 1994), DOD agreed that unnecessarily large inventories increase holding costs and acknowledged that holding cost rates that only cover storage costs may not be appropriate. For example, reducing inventories by quantities sufficient to close warehouses would result in savings that exceed storage costs. While it is difficult to precisely determine the costs to manage and maintain nonessential and excessive insurance stocks, our review and DOD’s comments indicate that these costs would be millions of dollars a year. We recommend that the Secretary of Defense direct the Secretary of the Navy and the Director, Defense Logistics Agency, to (1) periodically review insurance items to ensure that they are mission essential and stocked in allowable quantities and (2) dispose of existing nonessential and excess insurance stock. We further recommend that the Secretary of the Navy direct the Commanding Officer, ASO, to set the retention level for insurance items at one unit and change the disposal computer program so that the on-hand stockage floor for these items also is one unit. DOD generally agreed with the thrust of our recommendations but did not agree with most of our report findings (see app. I). We have evaluated DOD’s comments and continue to believe that our basic position is sound; that is, the insurance inventories contain nonessential and excessive stocks. Our comments on some of DOD’s specific statements are at the end of appendix I. With regard to our recommendations, DOD stated that it would issue a memorandum by June 30, 1995, (1) reemphasizing the need to review insurance requirements prior to stock replenishment and (2) directing the disposal of nonessential stocks. DOD also stated that the Navy will direct ASO to reduce insurance stocks where the stockage is not in compliance with DOD regulations. The promised actions will be helpful, but they do not go far enough. Because insurance items are not expected to fail, most will not be reviewed if DOD only reviews those in need of stock replenishment. We believe that DOD should review all insurance items periodically to identify nonessential and excessive stocks. Over one half of the ASO insurance items have been in the supply system more than 10 years, and 87 percent have been in the supply system more than 5 years. Since then, requirements may have changed due to DOD downsizing and weapon system modification, obsolescence, or retirement. Unneeded insurance stocks tie up warehouse space and increase managerial burdens. To determine the adequacy of internal controls in the management of insurance items, we reviewed DOD, Navy, and DLA procedures; interviewed agency officials; and analyzed ASO and DISC computer files that contained insurance item data as of March and April 1994. ASO files included the master data file and disposal file. DISC files included the combined file (similar to a master data file) and contract file. By reviewing the files, we identified all insurance items managed by ASO and DISC. We then analyzed these items to determine which were classified as mission essential and which were stocked in quantities greater than one unit. We did not assess the reliability of these files. However, to validate insurance item data, we randomly sampled items that were not essential or exceeded authorized stock levels. The sample included 329 items from ASO files and 110 items from DISC files. We sent a questionnaire to the ASO and DISC item managers responsible for the sampled items. We asked the managers to validate and update the file information, provide opinions on the essentiality of the items and causes of excess stock buildups, and define the extent that excess stock was disposable. Using this data from the ASO managers, we projected the results to the universe from which the sample items were drawn at a 95-percent confidence interval. None of the DISC item managers had responded to the questionnaire at the time our fieldwork was completed. We performed our review between February and September 1994 in accordance with generally accepted government auditing standards. The head of a federal agency is required by 31 U.S.C. 720 to submit a written statement on actions taken on our recommendations to the Senate Committee on Governmental Affairs and the House Committee on Government Reform and Oversight not later than 60 days after the date of the report. A written statement also must be sent to the Senate and House Committees on Appropriations with the agency’s first request for appropriations made more than 60 days after the date of the report. We are sending copies of this report to the appropriate congressional committees; the Director, Office of Management and Budget; the Secretary of the Navy; and the Director, Defense Logistics Agency. Please contact me at (202) 512-5140 if you have any questions. The major contributors to this report are listed in appendix II. The following are GAO’s comments on the Department of Defense’s (DOD) letter dated November 28, 1994. 1. The item mission essentiality codes we used in our analysis are assigned to items to indicate their level of impact on the mission of applicable equipment in the event stocks are depleted. The military essentiality codes DOD said we should have used are assigned to indicate the military importance of a part in relation to a higher component, equipment, or weapon. Both sets of codes should provide the same indication of mission essentiality and be based on input from technical personnel. We analyzed the item mission essentiality codes because the Aviation Supply Office’s (ASO) records showed these codes for 92 percent of the insurance items. We could not analyze the military essentiality codes because these codes were not shown on the records ASO provided us for over 99 percent of the insurance items. After receiving our draft report, DOD asked the Navy to determine the distribution of military essentiality codes. This analysis showed that 58 percent of the ASO insurance items were assigned a mission essential code, less than 1 percent were assigned a not mission essential code, and the remaining 41 percent were blank and not assigned a code. The Navy agreed that insurance items that are not coded as mission essential must be validated. 2. Although engineers may make essentiality determinations, we opted to send the questionnaire to the managers that have overall responsibility for the items. In making this decision, we consulted with ASO officials and asked them to review the questionnaire. We made their suggested changes and pretested the questionnaire with item managers before it was finalized. At no time in the process did ASO officials indicate that the questionnaire should be sent to engineers rather than item managers. Furthermore, we did not ask the item managers to refrain from consulting with engineers, equipment specialists, end users, or others with greater technical knowledge in preparing the responses. In fact, the responses indicated that such consultations did take place in some cases. 3. We did receive responses to our questionnaire. In July 1994 we asked the Defense Industrial Supply Center (DISC) to complete the questionnaire for 110 insurance items, but DISC did not respond to the request by the time our fieldwork was completed. However, in October 1994, after receiving our draft report, the Defense Logistics Agency (DLA) provided responses for 64 of the 110 items managed by DISC. The responses indicated that 14 percent of the insurance items were mission essential, 43 percent were not mission essential, and the item managers did not know if the items were mission essential for the remaining 43 percent. Also, the responses indicated that 57 percent of the insurance items were stocked in quantities that exceeded the authorized level of one unit. 4. At least two sections of the cited regulation state that one unit of an item may be stocked for insurance purposes. For example, page 3-3 states that essential items with no forecast of failure may be stocked as insurance items in quantities not to exceed one replacement unit. 5. We have modified the report to address DOD’s comments on holding costs. 6. At the completion of our fieldwork, we furnished ASO and DISC with written summaries of our findings and potential recommendations. We held an exit conference with ASO officials and gave them the opportunity to comment on the summary. We gave DISC officials the same opportunity, but they did not provide any comments. All of these actions were taken before the draft report was submitted to DOD for formal review and comment. In addition, prior to the ASO exit conference and the DISC exit conference offer, we had numerous discussions with ASO and DISC officials during the course of the review. 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Summary: GAO reviewed the Navy's and the Defense Logistics Agency's (DLA) management of their spare parts and supplies inventories, focusing on whether their insurance stocks are limited to: (1) mission-essential parts; and (2) one replacement unit as required by Department of Defense (DOD) regulations. GAO found that: (1) the Navy and DLA stock millions of dollars of unnecessary insurance items that are not mission-essential; (2) the Navy and DLA frequently exceed their authorized maximum stock levels, contrary to DOD regulations; (3) the Navy and DLA do not periodically review insurance items to ensure that they are mission-essential and stocked in appropriate quantities because they lack the internal controls necessary to prevent excessive stock buildup; (4) DOD downsizing, weapon system obsolescence and retirement, and stock retention policies have also contributed to excessive inventories; and (5) the excessive inventories cost DOD millions of dollars to procure, manage, and maintain.