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). 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 50 percent of the $734 million in sales came from name-brand, fast-food outlets. 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 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. 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. 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 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. 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. 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. 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. 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 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. 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, 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. 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. 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 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 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. 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. 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. 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 name- brand 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 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 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 fast- food 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. 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. 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 name- brand, 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. 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 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. 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. 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 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 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. 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 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. 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 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 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. 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 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 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 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 Data was not available from NEXCOM. NEXCOM officials told us that this number is likely insignificant. 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. 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. 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. 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.

Summary: The military exchange services operate a wide range of retail activities, such as department stores, florist shops, barber and beauty shops, gas stations, and restaurants. Hamburger restaurants represent a major segment of the exchange services' name-brand, fast-food sales. The exchange services use either a direct or an indirect method to operate these restaurants. 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 restaurant and directly employs and trains the personnel. In turn, the exchange service receives all of the revenues and profits and usually pays the company a licensing fee plus a percentage of the restaurant's 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 on the basis of restaurant's sales. Under this agreement, the exchange service receives a percentage of the restaurant's annual sales; annual licensing fees; and, in some cases, a signing bonus or minimum guaranteed commissions. GAO's analysis of fiscal year 1998 and 1999 financial data from the Army and Air Force Exchange Service and the Navy Exchange Service Command showed that the indirect method of operating name-brand hamburger restaurants was more profitable than the direct method, regardless of the restaurants' sales volume, restaurant type (free-standing or part of a food court), or location. GAO's 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. Other factors important in choosing between direct and indirect methods include financial and operating risks, customer service issues, employment opportunities for military dependents, and management control of a restaurant's operations. Although the Department of Defense's (DOD) policy on name-brand, fast-food restaurants establishes preferences for when the direct and indirect methods should be used, it does not provide enough guidance or criteria to determine which method to use or when it is appropriate to deviate from the policy. Also, 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 they believe best suit their particular circumstances.