The C-17 is being developed and produced by McDonnell Douglas. The Congress has authorized procurement of 40 C-17 aircraft through fiscal year 1996. As of October 1, 1995, McDonnell Douglas had delivered 22 production aircraft to the Air Force. In November 1995, the Department of Defense (DOD) announced plans to buy an additional 80 C-17 aircraft. In addition to procuring the aircraft, the Air Force is purchasing spare parts to support the C-17. The Air Force estimates the total cost for initial spares—the quantity of parts needed to support and maintain a weapon system for the initial period of operation—for the first 40 C-17s to be about $888 million. In January 1994, we reported that the Air Force had frequently ordered C-17 spare parts prematurely. We noted that premature ordering occurred because the Air Force used inaccurate and outdated information, bought higher quantities than justified, or did not follow regulations governing the process. As a result, DOD revised its guidance to limit the initial procurement of spares, and the Air Force canceled orders for millions of dollars of C-17 parts. Initial spares for the C-17 are being procured under two contracts. Some are being provided under the C-17 development contract through interim contractor support. That support, which started in mid-1993, involves providing spares and technical support for two C-17 squadrons through June 1996. As of May 31, 1995, the Air Force had spent about $198 million for interim contractor support. The remaining initial spares are being procured under contract F33657-81-C-2109 (referred to in this report as contract-2109). Under this contract, the Air Force, as of May 31, 1995, had obligated $120 million for initial spares, but negotiated prices for only about $29 million of the spares. The $91 million balance was the amount obligated for parts ordered on which prices had not been negotiated. McDonnell Douglas produces some spare parts in its facilities at the Transport Aircraft Division at Long Beach, California, where the C-17 is being produced, or at other locations, such as its Aerospace-East Division at St. Louis. It also subcontracts for the production of parts. The subcontractors may be responsible for all aspects of part production or McDonnell Douglas may furnish materials or complete required work. The Air Force paid higher prices for 33 spare parts than appears reasonable when compared to McDonnell Douglas’ historical costs. The 33 spare parts were ordered under contract-2109 and manufactured by McDonnell Douglas’ St. Louis Division. The Long Beach Division had previously purchased them from subcontractors for production aircraft at much lower costs. The St. Louis Division’s estimated costs were from 4 to 56 times greater than the prices that Long Beach had paid outside vendors several years earlier. The parts were in sections of the C-17 assembled by the Long Beach Division for the first four aircraft, but assembled by the St. Louis Division for subsequent aircraft. For 10 parts, McDonnell Douglas had previously purchased the complete part from a subcontractor. For the other 23 parts, it had furnished material to a subcontractor that manufactured the part. While our examination of price increases was limited to 33 spare parts, an Air Force-sponsored should-cost review identified potential savings of $94 million for the C-17 program if work is moved from McDonnell Douglas’ St. Louis Division to outside vendors or other McDonnell Douglas facilities. Air Force officials said that the $94 million savings related only to components for production aircraft. They said that the savings would be higher if spare parts were included. We identified 10 parts—7 hinges on the air inlet door to the C-17’s air conditioning system, 2 cargo door hooks, and a door handle on the C-17’s vertical stabilizer access door—that McDonnell Douglas had previously purchased complete from a subcontractor at much lower costs. Information on previous purchase costs, McDonnell Douglas’ manufacturing costs, and the price that the Air Force paid for each of these spare parts are included in appendix I. Details on one of the hinges follow. The Air Force paid $2,187 for one hinge on the air inlet door to the C-17’s air conditioning system. The hinge (see fig. 1) is aluminum, about 4 inches long, 2 inches wide, and ranges from about 1/16 of an inch to 1-3/8 inches thick. The Long Beach Division, which assembled the air conditioning inlet door for initial production, purchased 14 of these hinges from a subcontractor in 1988 for use on production aircraft at $30.60 each. It had also paid the vendor $541 for first article inspection and $2,730 for reusable special tooling. These costs, however, would not have been incurred on future orders. In 1992, McDonnell Douglas transferred the air conditioning inlet door assembly work to its St. Louis Division and that division made the hinge for production aircraft and for the spare part order. The estimated cost for the spare hinge was $1,745, and, with overhead, profit, and warranty factors, the Air Force paid $2,187 for it. The fact that the subcontractor had made the hinge from a special casting while the St. Louis Division machined the hinge from bar stock could be one cause of the higher price. We identified 23 parts—21 different cargo door hooks and 2 different hinge assemblies—where McDonnell Douglas had previously furnished material to a subcontractor who produced the parts at much lower costs. Information on previous purchase costs and McDonnell Douglas manufacturing costs are included in appendix II. Details on one of the door hooks follow. The Air Force paid $12,280 for one of the hooks. The hook (see fig. 2) is made of steel and is about 7 inches high, 3-1/2 inches wide, and about 4-1/2 inches thick. For the early production aircraft, the Long Beach Division had furnished material valued at $715 to an outside vendor in 1992 who manufactured this hook for $389 (exclusive of the material value). After initially using hooks for production aircraft provided from the Long Beach Division’s inventory, the St. Louis Division made them starting with production aircraft number 12. For the spares order under contract-2109, the St. Louis Division estimated “in-house” manufacturing costs (exclusive of material costs) at about $8,842. McDonnell Douglas officials said that the primary reason for moving various work from the Long Beach Division to the St. Louis Division was to recover from being behind schedule and that sufficient time was not available to procure parts from vendors. McDonnell Douglas officials also said that now that production deliveries are on schedule, they will be reviewing parts to identify the most affordable and effective manufacturing source and that 17 of the 33 parts have been identified as candidates to move out of St. Louis to achieve lower C-17 costs. DOD advised us that DPRO officials at McDonnell Douglas had estimated the cost difference between production by McDonnell Douglas versus subcontractors for the 33 parts to be $141,000 and, after further analysis,had determined that $65,000 was excessive. McDonnell Douglas refunded that amount in December 1995. Our review of the data submitted to support the pricing of selected spare parts orders showed that McDonnell Douglas’ St. Louis Division used outdated pricing information when proposing costs under intercompany work orders with the Long Beach Division for the C-17 spares. The St. Louis division used labor variance factors based on the second quarter of 1992 for proposing labor hours required for items produced in 1994. Most of these orders were negotiated with DCMC in mid-1994. As of May 31, 1995, DCMC had negotiated prices for 95 contract items made by the St. Louis Division with a total negotiated value of about $966,000. We reviewed data for 37 of these items with a negotiated total value of $347,000. We reviewed only labor variance factors and did not address other rates and factors such as the miscellaneous production factor. We found that the selected items were overpriced by $117,000, or about 34 percent of the negotiated value of the items reviewed. For example, McDonnell Douglas, in developing the basic production labor hours estimate for a hinge assembly multiplied machine shop “target” hours by a variance factor of 2.33 and sheet metal target hours by a variance factor of 2.5. Data for the first quarter of 1994 showed a conventional machine shop variance of 1.26 and a sheet metal variance of 1.60. Because most work for this item took place in the first half of 1994 and the prices were negotiated in June 1994, the 1994 variance rates should have been used for pricing the item. Instead, McDonnell Douglas used rates based on the second quarter of 1992, which were higher. A price of $42,587 was negotiated based on the 1992 data. Using the data for the first quarter of 1994, the price would have been $26,458, a difference of $16,129, or about 38 percent lower than the negotiated price. After we brought these issues to the attention of DOD officials, they acknowledged that more current labor variance data should have been used and sought a refund. McDonnell Douglas made a refund of $117,000 in December 1995. Our review indicated that the profits awarded for some orders under contract-2109 appear higher than warranted. DFARs requires the use of a structured approach for developing a government profit objective for negotiating a profit rate with a contractor. The weighted guidelines approach involves three components of profit: contract type risk, performance risk, and facilities capital employed. The contracting officer is required to assess the risk to the contractor under each of the components and, based on DFARs guidelines, calculate a profit objective for each one and, thus, an overall profit objective. As a general matter, the greater the degree of risk to the contractor, the higher the profit objective. For example, the profit objective for a fixed-price contract normally would be higher than that for a cost-type contract because the cost risk to the contractor is greater under the former. Consequently, in its subsequent price negotiations, the government normally will accept a higher profit rate when a contractor is accepting higher risks. The price of spare orders under contract-2109 were to be negotiated individually. However, rather than calculate separate profit objectives and negotiate profit rates for individual orders, DPRO and McDonnell Douglas negotiated two predetermined profit rates, documented in a memorandum of agreement, that would apply to subsequent pricing actions. The profit rates were 10 percent for parts that McDonnell Douglas purchased from subcontractors, and 15 percent for spare parts that McDonnell Douglas manufactured. Our review indicates that the use of these rates for many later-priced spares resulted in higher profits for the contractor than would have been awarded had objectives been calculated and rates negotiated when the orders actually were priced. Based on profit rates of 6 percent for purchased parts and 13 percent for parts made in-house, both of which could have been justified according to our calculations, McDonnell Douglas would have received less profit. For example, applying these lower profit rates to the $29 million of negotiated spare part orders as of May 31, 1995, would have reduced the company’s profit by $860,000. After we presented our information in October 1995, DCMC directed that the memorandum of agreement, which was scheduled to either expire or be extended on November 1, 1995, be allowed to expire and that future profit objectives be established on an order-by-order basis. DOD officials agreed that a single profit analysis should not be used for C-17 spare parts. In developing a profit objective for contract-2109, the contracting officer assigned a value for contract type risk based on firm, fixed-price contracts. However, negotiations of prices for spare part orders were conducted, in many cases, after the vendor or McDonnell Douglas had incurred all costs and delivered the spares. These conditions lowered the contractor’s risk for those parts far below what normally would be expected for a firm, fixed-price contract. The risks were more like those that exist for cost-type contracts, for which the weighted guidelines provide lower profit objective values. Of the 40 parts made in-house that we reviewed, McDonnell Douglas had delivered 25 (63 percent) of the parts at the time of price negotiations with the government. Five of the remaining 15 items were delivered during the month of price negotiations, and all were delivered within 3-1/2 months of price negotiations. Of the 55 “buy” spare parts we reviewed, McDonnell Douglas had established prices with its vendor for 45 (82 percent) of the parts. Using one order as an example, McDonnell Douglas (1) negotiated spare parts prices with its subcontractor on January 25, 1993; (2) negotiated prices with the government on April 11, 1994; and (3) scheduled the parts for delivery on May 27, 1994. Thus, for both make and buy items, a substantial portion of the contractor’s costs had been known at the time of the price negotiations. Section 217.7404-6 of DFARs requires that profit allowed under unpriced contracts reflect the reduced risk associated with contract performance prior to negotiations. Consistent with this requirement, the weighted guidelines section (215.971-3) requires the contracting officer to assess the extent to which costs have been incurred prior to definitization of a contract action and assure profit is consistent with contractor risk. In fact, the guidelines provide that if a substantial portion of the costs has been incurred prior to definitization, the contracting officer may assign a contract type risk value as low as zero, regardless of contract type. A DPRO representative said that, in negotiating the memorandum of understanding, DPRO knew that the two profit rates for later application would not be perfect in every case. He said, however, that they were expected to be off in one direction as often as in the other, creating an overall fair agreement. The representative noted, for example, that while deliveries for the orders we reviewed were near the negotiation dates, the memorandum’s rates also would apply to orders with deliveries more than 2 years in the future, where minimal costs have been incurred. In addition, the representative stated that a significant number of parts would be undergoing design changes because a baseline configuration for the C-17 did not exist. The representative explained that McDonnell Douglas is responsible for replacing spares affected by design changes until 90 days after reliability, maintainability, and availability testing, which was completed on August 5, 1995, and that any additional cost for such replacements would have to be absorbed by McDonnell Douglas. Finally, the representative noted that the minimal cost history on C-17 spares would indicate a higher than normal contract type risk. We have no evidence to support the DPRO official’s view that profits based on the rates in the memorandum of agreement would balance out over time. In fact, DCMC let the agreement lapse and will calculate profit objectives and negotiate profit rates on an order-by-order basis. In addition, we noted that McDonnell Douglas initially received a 2-percent warranty fee on contract-2109 orders to cover both the risk of design changes and provide a standard 180-day commercial warranty. Furthermore, the profit agreement stated that McDonnell Douglas could submit additional warranty substantiation at any time and, if the data supported a different percent for warranty, the government would consider adjusting the percentage. Thus, the warranty fee is the contract mechanism the parties agreed to use to address the risks of replacement parts because of design changes. The contracting officer, in developing a profit objective for buy orders (complete spare parts purchased from an outside vendor) under contract-2109, used a higher rate for performance risks than was warranted. The DFARs’ weighted guidelines provide both standard and alternate ranges for the contracting officer to use in calculating performance risk, which is the component of profit objective that addresses the contractor’s degree of risk in fulfilling the contract requirements. The standard range applies to most contracts, whereas the higher alternate is for research and development and service contracts that involve low capital investment in buildings and equipment. The guidelines provide that if the alternate range is used, the contracting officer should not give any profit for the remaining component, facilities capital employed, which focuses on encouraging and rewarding aggressive capital investment in facilities that benefit DOD. DCMC officials said that the alternate range was used in calculating the performance risk component on contract-2109 because McDonnell Douglas’ system could not provide an estimate to be used for purposes of calculating the facilities capital component. DPRO officials said that since the negotiation, McDonnell Douglas has developed the means to estimate facilities capital employed on its spares proposals. They said that using the standard range for performance risk and including facilities capital employed for spares orders yields a profit objective that is substantially the same as the profit objective calculated using the alternate range for performance risk. DOD concurred that DPRO should not have utilized the alternate range for performance risk, but repeated the DPRO’s assertion that using the standard range and including facilities capital employed yields essentially the same results. We reviewed DCMC’s data and found that using the alternate range for the performance risk component does not result in a substantially similar profit objective to that calculated by applying a factor for facilities capital employed. The contracting officer’s use of the alternate range for performance risk, combined with the use of a fixed-price value for contract type, led to the negotiation of a profit rate of 10 percent for the buy orders; in contrast, we calculated that using a cost-type contract risk factor, the standard range for performance risk, and McDonnell Douglas’ estimate of facilities capital employed would have resulted in an overall profit objective of 6 percent for the buy orders. In commenting on a draft of this report, DOD said that it had taken appropriate action to address our finding of overpricing. In addition to recovering $182,000, DOD indicated that DPRO at McDonnell Douglas will now screen all spares orders containing items to be made in-house to (1) look for possible conversion to buy items and (2) ensure that labor data is correct for all items made in the St. Louis Division. Moreover, DOD stated that DPRO no longer relies on a single profit analysis and, by completing a separate analysis for each order, DPRO will address the contract risk associated with each order. DOD acknowledged that it is possible to take issue with the contracting officer’s selection of risk factors and that DPRO should not have used the alternative range for performance risk in its profit analysis. However, DOD asserts that it would be misleading to infer that unjustified profits were paid to the contractor. We do not infer that the contractor received $860,000 in unjustified profits. Determining the appropriate amount of profits is a matter to be negotiated between DPRO and the contractor. However, we noted that (1) lower rates were justified under the weighted guidelines and (2) rates of 6 percent for purchased parts and 13 percent for parts made in-house could be justified. While the results of our review cannot be be projected to all C-17 spare parts, using the lower profit rates for the $29 million of negotiated spare parts orders as of May 31, 1995, would have reduced the company’s profit by $860,000. Our subsequent analysis raises some questions about the DOD statement that DPRO, by making a separate profit analysis for each order, will address the contract type risk associated with each order. Our review of an order negotiated in January 1996 based on a separate profit analysis indicated that the DPRO’s profit analysis continues to not reflect the reduced risk when most costs have been incurred prior to price negotiations. While the negotiated profit rate was 8.6 percent, or 1.4 percent lower than the previously negotiated rate, the amount of profit allowed for contract type risk continues to appear higher than justified by the weighted guideline and DFARs. In this regard, DPRO noted that McDonnell Douglas’ cost “amounts to only 46 hundreths of one percent” and “you are being paid all your costs and the parts have already been shipped, thereby reducing your risk to a very low degree.” However, the contract risk factors were at the midpoint range and higher for a firm, fixed-price contract. The stated reason for this was that the design could change, necessitating a recall. While DPRO discontinued using the memorandum of understanding profit rates, we remain concerned that the negotiated profit rates may not reflect the reduced contract type risk when essentially all costs have been incurred. DOD’s comments are reprinted in their entirety in appendix III. To select spare parts for our review, we analyzed reports developed by McDonnell Douglas’ data system that included historical and current information on spare parts orders—for example, the negotiation date, negotiation amount, and delivery date on current/previous orders. For our review, we only considered spare parts orders for which prices had been negotiated as of May 31, 1995. As of that date, prices for orders involving 696 spare parts had been negotiated, with a value of about $29 million. We selected spare parts for a more detailed review based on current/previous cost, intrinsic value, and nomenclature. Our selection of parts was judgmental and our results cannot be projected to the universe of C-17 parts. We reviewed the contractor’s and the DPRO’s contract and pricing files, and discussed the pricing issues with selected contractor and DCMC officials. As a result of rather significant cost increases for a number of spare parts that had the manufacturing/assembly effort transferred to the contractor’s plant in St. Louis, we obtained additional documentation from the contractor’s plant in St. Louis and DPRO. We reviewed the DFARs guidance relating to the use of weighted guidelines in establishing a profit objective. We also reviewed the memorandum of agreement that was negotiated by DPRO for contract-2109 and discussed the basis for the negotiated profits with DOD and DPRO officials. In assessing the value assigned to contract type risk, we reviewed data on 95 spare parts with a total negotiated price of about $3 million out of 696 spare parts with a total negotiated price of about $29 million, or about 14 percent of the parts. Our review of selected spare parts cannot be projected to all C-17 spare parts. However, to illustrate the potential effect of lower profit rates, we calculated a potential reduction using spare parts orders negotiated as of May 31, 1995. We conducted our review between November 1994 and September 1995 in accordance with generally accepted government auditing standards. As agreed with your office, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days after its issue date. At that time, we will send copies to the Secretaries of Defense and the Air Force; the Director, Office of Management and Budget; and other interested parties. We will make copies available to others upon request. If you or your staff have any questions about this report, please contact me on (202) 512-4841. The major contributors were David Childress, Larry Aldrich, Kenneth Roberts, and Larry Thomas. The first copy of each GAO report and testimony is free. Additional copies are $2 each. 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Summary: Pursuant to a congressional request, GAO reviewed the pricing of certain spare parts for the C-17 aircraft, focusing on those spare parts that experienced significant price increases when McDonnell Douglas decided to produce them in-house rather than purchase them from outside vendors. GAO found that: (1) GAO's review indicates that the Air Force paid higher prices for spare parts than is justified; (2) for 33 selected spare parts formerly procured under subcontracts, costs are from 4 to 56 times higher after McDonnell Douglas moved the work in-house; (3) for example, McDonnell Douglas paid an outside vendor $389 to machine a door hook that it subsequently machined in-house at its St. Louis Division at an estimated cost of $8,842; (4) costs for some spare parts are higher than justified because McDonnell Douglas used outdated pricing data that overstated its proposed prices; (5) in developing the proposed costs of selected spare parts, McDonnell Douglas used outdated labor variance factors, which resulted in prices being overstated by 34 percent ($117,000) for 37 parts; (6) the profits awarded on some orders under contract-2109 appear higher than warranted; (7) the contracting officer used Defense Federal Acquisition Regulation Supplement guidelines to calculate profit objectives and negotiate profit rates with the contractor that are documented in a memorandum of agreement; (8) the contracting officer developed the government's objectives based on the risks of a fixed-price contract; (9) however, most costs were known when the order prices were negotiated; therefore, the contractor's risks were lower than in a fixed-price environment; (10) also, the contracting officer used a higher performance risk factor than appears appropriate when McDonnell Douglas is buying spare parts from subcontractors; and (11) based on profit rates that GAO's calculations suggest could have been justified, McDonnell Douglas would have received less profit. GAO also found that: (1) as GAO discussed its findings with Department of Defense (DOD) officials during GAO's review, they began taking actions to address those findings; (2) for example, the Defense Contract Management Command's Defense Plant Representative Office at McDonnell Douglas calculated that the overpricing of spare parts was $182,000 and recovered that amount from McDonnell Douglas in December 1995; and (3) DOD stated that other actions are being taken to prevent these overpricing problems on other spare parts.