On June 10, 1975, the U.S. government executed a Memorandum of Understanding with the governments of Belgium, Denmark, the Netherlands, and Norway to produce F-16 aircraft under a program known as the F-16 Multinational Fighter Program. Of the 998 aircraft produced under this program, the U.S. Air Force purchased 650 and the European participating governments purchased the remaining 348. Under the ongoing MLU program, the Europeans are upgrading their F-16 aircraft by equipping them with new cockpits and avionics systems. On behalf of the four European participating governments, the U.S. Air Force awarded prime contracts to Lockheed Martin Tactical Aircraft Systemsand Northrop Grumman Corporation valued at $622.7 million and $106.5 million, respectively, to provide the aircraft upgrades. The U.S. government participated in the development phase of the MLU program, but it withdrew from the production phase in November 1992. The European countries’ Supreme Audit Institutions (SAIs) have raised a number of issues regarding the pricing of the MLU contracts. The U.S. and European participating governments agreed that they would “endeavor to establish the same price for the same articles when they were procured under the same conditions from the same source.” Due to the proprietary nature of the information affecting the negotiation of the contracts, SAIs are precluded from having access to this information. On December 15, 1994, a meeting, involving representatives from the U.S. and the European participating governments, was held during which agreement was reached to provide assurance that the MLU contract prices were fair and reasonable. Among the issues discussed were the rates and factors used to price the MLU contracts. According to the minutes of the meeting, the European representatives were assured that the “. . . rates and factors that are used for MLU contracts are the same for all other LFWC [Lockheed Fort Worth Company] F-16 contracts with the U.S. Government.” Since these rates and factors are proprietary, the Netherlands representative asked if the United States could provide certification that the same rates are used on all U.S. government contracts. The Defense Plant Representative Office Commander agreed to provide the certification and did so on March 24, 1995. Lockheed Martin and Northrop Grumman proposed and Air Force negotiators used rates and factors to price the two MLU prime contracts that were different from those used to price contemporaneous U.S. government contracts. Also, Air Force negotiators used two incorrect rates in pricing the Northrop Grumman prime contract. These two conditions increased the prime contract prices by a total of $9.4 million. The rates and factors used to price the Lockheed Martin MLU contract were not the same as those used to price U.S. government contracts. Instead, on December 23, 1994, Lockheed Martin proposed a “special” set of rates to price the MLU contract rather than using the lower FPRA rates in effect at that time. The Air Force used the special rates in negotiating the MLU contract prices. This action increased the contract price by $8 million. During the December 1994 working group meeting involving U.S. and European representatives, the Defense Plant Representative Office Commander stated he would certify that the rates used to price the MLU contract would be the same as those used to price all U.S. government contracts. Subsequently, in a March 24, 1995, written certification, the Commander stated “. . . that the applicable FPRA rates and factors used in the MLU program are the same as all other programs negotiated between the LFWC and the U.S. Government.” However, contrary to the Commander’s certification, the Air Force negotiated two other contracts with Lockheed Martin on the same day the MLU contract was negotiated using lower FPRA rates and factors. Neither Lockheed Martin nor the Air Force withdrew from the FPRA that was in effect at the time the MLU contract price was agreed to. The Defense Federal Acquisition Regulation Supplement stipulates that FPRA rates must be used to price contracts unless waived by the head of the contracting activity. No such waiver was requested or obtained for the special rates used to price the MLU contract. Furthermore, there was no evidence in the contract negotiation records or files that the special rates were audited by DCAA or approved for use by the Defense Plant Representative Office. Lockheed Martin proposed and Air Force negotiators used the lower FPRA rates to establish the negotiation objective for the contract price. Before contract price agreement was reached, however, Lockheed Martin provided Air Force negotiators the special set of rates and factors that they accepted and used to price the contract. Lockheed Martin officials told us a special set of rates and factors was required to negotiate the MLU contract because the existing FPRA was only valid through calendar year 1997. They explained that the MLU contract performance period covered calendar years 1993 through 2001 and that rates and factors for the outyears were required. They believe that the special rates benefited the MLU customers because a new FPRA, negotiated shortly after the MLU contract, included higher rates than those used for the MLU contract. In responding to a draft of this report, the Air Force agreed a special set of rates and factors was used to price the MLU contract, but it believed the use of those rates and factors was in the best interest of the European participating governments. The Air Force also stated that the Defense Plant Representative Office Commander signed the certification in good faith, based on his knowledge at that time, and with full intention of being consistent with the pricing agreement between the U.S. and the European participating governments. The Air Force further stated that the Defense Plant Representative Office was negotiating a new FPRA while MLU contract negotiations were going on and had already offered Lockheed Martin higher rates and factors than were in the existing FPRA. The Air Force pointed out that Lockheed Martin would never have accepted the lower existing FPRA rates and factors, which covered the period 1993 through 1997. We agree that the certification was signed in good faith. We also agree that the existing FPRA extended only through 1997 and that rates and factors were needed to cover the MLU contract performance period. However, when changing conditions cause rates in an FPRA to be no longer valid, defense procurement regulations provide approved methods for dealing with the situation—either withdraw from the rate agreement or obtain a waiver from the head of the contracting activity. Air Force negotiators did neither. We found that the Defense Plant Representative Office had issued recommended rates and factors covering 1998 and 1999. Thus, Air Force negotiators—using the existing FPRA and recommended rates—had rates and factors covering 1993 through 1999. According to negotiation records, this period accounted for 99 percent of the MLU contract value. Furthermore, the $8-million increase to the MLU contract is not due to higher rates and factors for the years beyond the FPRA period. Rather, the increase is due to increased rates and factors for 1993 through 1997—the same period covered by the existing FPRA. In addition, the MLU contract awarded to Northrop Grumman for radar systems encountered the same situation as the Lockheed Martin contract—that is, it extended beyond the period covered by the existing FPRA. However, in contrast to the Lockheed Martin situation, the Air Force used existing FPRA rates and factors to price the radar contract. The contract performance period extended into the year 2002, while the existing FPRA went through only 1996. Northrop Grumman proposed and the Air Force used the existing FPRA rates and factors and projected these rates and factors over the remaining contract performance period. Northrop Grumman proposed and the Air Force accepted a G&A overhead rate established for pricing foreign military sales contracts rather than a lower domestic rate established for pricing U.S. government contracts. Use of the G&A rate for foreign military sales contracts increased the MLU contract price by $1.3 million. Northrop Grumman officials told us they used the G&A rate for foreign military sales contracts because of the additional costs in doing business with foreign customers. They also stated they were unaware of any requirement to use the same rates applied to U.S. government contracts. They further stated that such a requirement was not made known to the corporation in the Air Force’s request for proposal or subsequent contract award. In commenting on a draft of this report, the Air Force pointed out that use of the foreign military sales G&A rate was proper on the Northrop Grumman MLU contract. The Air Force advised us that the contractor could not use and the Air Force could not accept the domestic G&A rate for pricing the contract because it would be a misallocation of costs. The Air Force also pointed out that use of the foreign military sales G&A rate did not violate the intent or the spirit of the agreement between the U.S. and the European participating governments. It should be noted that while the Air Force contends that it would have been improper to use the domestic G&A rate for pricing the Northrop Grumman contract, the Air Force used a domestic G&A rate to price the Lockheed Martin MLU contract. The Air Force did not explain this inconsistency. In addition to using the higher G&A rate for foreign military sales contracts, Air Force negotiators used two incorrect rates in pricing the MLU contract, which caused its price to be increased by $163,600. The Air Force concurred that use of the incorrect rates was an oversight. In total, the MLU contract price was increased by $1.4 million as a result of using the higher G&A rate for foreign military sales contracts and two incorrect rates. DCAA conducted preaward audits of both prime contract proposals and questioned various costs. DCAA also reported large amounts of proposed subcontract costs as unresolved because several subcontractor price proposals had not been audited at the time of its preaward audits. Price negotiation memorandums showed DCAA helped the Air Force evaluate updated contractor proposals during fact-finding prior to contract price negotiations. In addition to making specific recommendations on proposed costs, DCAA also provided Air Force negotiators with information on deficiencies in the contractors’ estimating systems, material management and accounting systems, and other operations. The price negotiation memorandums clearly show that Air Force negotiators used DCAA recommendations to assist in establishing objectives and negotiating lower prices for the two prime contracts. The memorandum for the Lockheed Martin contract, for example, shows DCAA reported a substantial amount of proposed subcontract costs as unresolved because audits of the subcontracts had not been completed at the time of DCAA’s review. DCAA reported the same condition for the Northrop Grumman contract. Audits of the subcontractor proposals were subsequently obtained, and Air Force negotiators used the information in negotiating the contract prices. Air Force negotiators also used other DCAA recommendations in negotiating the prices of the contracts. On the Northrop Grumman contract, for example, they extensively used DCAA’s recommendations on proposed material costs. The price negotiation memorandum showed Air Force negotiators were able to obtain most of DCAA’s recommended cost reductions for material. We reviewed the fairness and reasonableness of subcontract and material costs negotiated in the prime contracts because these costs comprised about 88 percent of the combined negotiated contract prices. Subcontracts and material under the Lockheed Martin contract totaled $572.7 million, or about 92 percent, of the $622.7-million contract price. Subcontracts and material under the Northrop Grumman contract comprised $66.2 million, or about 62 percent, of the $106.5-million price. For competitively priced subcontracts, we examined the supporting records and, if adequate competition occurred, we accepted the prices as fair and reasonable. For noncompetitively priced subcontracts, we examined the negotiation records to determine if appropriate safeguard techniques were used to negotiate the prices. At the time of the prime contract price agreement dates, Lockheed Martin had negotiated firm prices for 10 of its 11 major subcontracts, and Northrop Grumman had negotiated firm prices for both of its major subcontracts. The contractors used the pricing techniques required by the Federal Acquisition Regulation in negotiating subcontract prices. Subcontract files and other records showed that Lockheed Martin and Northrop Grumman (1) obtained cost or pricing data, (2) conducted cost analyses, (3) conducted price negotiations, and (4) and obtained certificates of current cost or pricing data. The cognizant Defense Plant Representative Offices also obtained audits from DCAA or the participating governments’ audit agencies of the subcontractor price proposals and provided the audit reports to Air Force negotiators. For the subcontract that was not priced at the time of prime contract price agreement, Lockheed Martin, as required by the Federal Acquisition Regulation, obtained cost or pricing data from the subcontractor and prepared a cost analysis of the subcontract proposal. Air Force negotiators accepted the proposed and negotiated subcontract prices as fair and reasonable based on the prime contractors’ evaluation and negotiation efforts. We did not examine material items on the Lockheed Martin contract because they comprised less than 1 percent of the contract price. As for the Northrop Grumman contract, we examined the pricing of selected material items because material costs comprised about 9 percent of the contract price. Northrop Grumman used appropriate safeguard techniques to price material items. None of the eight high dollar items we selected for review were priced at the time of prime contract price agreement. Northrop Grumman based its proposed prices for four of the items on supplier competitive quotations. Northrop Grumman received multiple quotations for the four items; therefore, we accepted the competitive prices as fair and reasonable. Northrop Grumman based its proposed prices for the other four items on noncompetitive quotations, and it conducted price analyses for the items. For two of the items, the price quotations fell below the maximum prices established by the price analyses, and Northrop Grumman accepted the proposed prices as fair and reasonable. Quotations for the other two items were higher than the maximum price established by the price analyses, and Northrop Grumman decremented the quotations and submitted the lower prices to Air Force negotiators. During prime contract price negotiations, Air Force negotiators applied an additional decrement against the proposed prices for all eight items. There are indications that material is overpriced by as much as $947,000 under the two prime contracts because the prime contractors did not provide government negotiators with accurate, complete, and current data available for the items at the time of the contract price agreement dates. We provided this information to the cognizant DCAA offices, and they are reviewing material prices in both prime contracts to determine the extent of overpricing. The amount of overpricing may change as DCAA continues its review. As requested, we reviewed the pricing of the subcontracts Lockheed negotiated with Hazeltine for the advanced identification friend or foe system and with Honeywell for the color multifunction display system. The Hazeltine subcontract was awarded on a competitive basis, while the Honeywell subcontract was awarded on a noncompetitive basis. The subcontract awarded to Hazeltine was competed between Hazeltine and three other vendors. Lockheed Martin subjected the responsive proposals to a technical evaluation, management evaluation, risk analysis, and cost evaluation and determined that Hazeltine had the lowest risk approach with the highest probability of successful completion. Hazeltine was the only supplier that proposed to meet all of the technical requirements. Lockheed Martin concluded Hazeltine’s proposed price was fair and reasonable and awarded the subcontract. Air Force negotiators also accepted the subcontract price as fair and reasonable. Lockheed Martin used the same safeguard techniques in negotiating the Honeywell subcontract that are required to be used in negotiating subcontracts under U.S. government prime contracts. There was not an FPRA with Honeywell at the time the subcontract price was negotiated; however, recommended rates and factors had been issued for Honeywell contracts. Lockheed Martin used the recommended rates and factors in negotiating the subcontract price. Air Force negotiators accepted the negotiated price as fair and reasonable. Air Force and contractor officials reviewed a draft of this report and their comments have been incorporated in the text where appropriate. Their comments are presented in their entirety in appendixes I, II, and III. SAIs selected two prime contracts for review. The first prime contract involved the letter contract the Air Force awarded to Lockheed Martin on August 17, 1993. The contract provides for the production of modification kits to upgrade the cockpit and avionics systems on the F-16 aircraft. The Air Force and Lockheed Martin agreed on the contract price on April 21, 1995, and the final contract was signed on June 13, 1995. The second prime contract involved a letter contract the Air Force awarded to Northrop Grumman on December 3, 1993. The contract provides for the production of modification kits for the AN/APG-66(V)2 fire control radar. The Air Force and Northrop Grumman agreed on the contract price on July 15, 1994, and the final contract was signed on September 27, 1994. SAIs also selected two subcontracts for review. Both were awarded under the prime contract to Lockheed Martin. The first involved the subcontract Lockheed Martin awarded to Honeywell (purchase order 354) on October 30, 1995, for the production of the F-16 color multifunction displays. The second involved the subcontract Lockheed Martin awarded to Hazeltine (purchase order 4XU) on September 24, 1993, for the production of the advanced identification friend or foe combined interrogator/transponder system. To determine whether the rates and factors used to price the two MLU prime contracts were the same as those used to price U.S. government contracts, we reviewed Air Force negotiation records to identify the rates and factors used for the MLU contracts. We then compared the MLU rates and factors to those included in FPRAs and forward pricing rate recommendations in effect at the time the MLU contracts were negotiated. Where differences were identified, we determined the effect on contract prices. We performed similar work on the Honeywell subcontract. We discussed the rates and factors with contractor, Air Force, DCAA, and Defense Plant Representative Office officials. To determine how Air Force officials used DCAA audit recommendations in negotiating prices for the prime contracts, we reviewed the DCAA preaward audit reports and recommendations. We evaluated contract negotiation records to determine how Air Force negotiators used DCAA’s work in establishing negotiation objectives and negotiating the contract prices. We discussed the use of the audit recommendations with DCAA and Air Force officials. To determine whether subcontract and material costs included in the contract prices were fair and reasonable, we compared the pricing safeguard techniques used by the contractors with those required by the Federal Acquisition Regulation and the Defense Federal Acquisition Regulation Supplement. We verified that, when required, the contractors obtained cost or pricing data, conducted cost or price analyses, carried out negotiations with subcontractors and vendors, and obtained certificates of current cost or pricing data. We also determined whether DCAA or audit agencies of the European participating governments made audits of the subcontractor price proposals. In addition, we examined negotiation records for the subcontracts and material items and discussed them with contractor and Air Force officials. We performed our work between May and August 1996 in accordance with generally accepted government auditing standards. We are sending copies of this report to the Secretaries of Defense and the Air Force; the F-16 System Program Director; the Director, Defense Contract Audit Agency; the Commander, Defense Contract Management Command; and the Chief Executive Officers of Lockheed Martin and Northrop Grumman Corporations. Copies will be made available to others upon request. If you or your staff have questions about this report, please contact me at (202) 512-4841 or David E. Cooper at (202) 512-4587. Major contributors to this report are listed in appendix IV. Joe D. Quicksall, Assistant Director Jeffrey A. Kans, Evaluator Kimberly S. Carson, Evaluator The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. U.S. General Accounting Office P.O. Box 6015 Gaithersburg, MD 20884-6015 Room 1100 700 4th St. NW (corner of 4th and G Sts. NW) U.S. General Accounting Office Washington, DC Orders may also be placed by calling (202) 512-6000 or by using fax number (301) 258-4066, or TDD (301) 413-0006. Each day, GAO issues a list of newly available reports and testimony. To receive facsimile copies of the daily list or any list from the past 30 days, please call (202) 512-6000 using a touchtone phone. A recorded menu will provide information on how to obtain these lists.

Summary: GAO reviewed the pricing of selected contracts and subcontracts awarded under the F-16 Aircraft Mid-Life Update (MLU) Program, designed to develop, produce, and install upgrades to F-16 fighter aircraft owned by Belgium, Denmark, the Netherlands, and Norway, focusing on: (1) differences between the rates and factors used to price two selected prime contracts and those used to price contemporaneous U.S. contracts; (2) how the Air Force used Defense Contract Audit Agency (DCAA) recommendations in negotiating prime contract prices; and (3) whether the prime contracts' prices for material and subcontract costs were fair and reasonable. GAO found that: (1) the prime contractors proposed and Air Force negotiators accepted rates and factors to price the two MLU contracts that were different from those used to price contemporaneous U.S. government contracts; (2) the contract prices for the European participating governments were $9.4 million higher due to the use of different rates and factors; (3) the Defense Plant Representative Office Commander certified that the forward pricing rate agreement (FPRA) rates and factors used to price the Lockheed Martin MLU contract were the same as those used to price all other contracts awarded to Lockheed Martin during the effective period of the agreement; (4) despite this certification, a special set of higher rates and factors was used to price the MLU contract rather than those called for in the FPRA; (5) for the Northrop Grumman contract, Air Force negotiators used a general and administrative overhead rate established for use in pricing foreign military sales rather than a lower domestic rate established for pricing U.S. government contracts; (6) Air Force negotiators also used two incorrect rates in pricing the MLU contract; (7) DCAA conducted preaward audits of the prime contractors' price proposals, questioned various costs, and reported large amounts of unresolved costs because audits had not been made of several subcontractor price proposals; (8) except for the rates and factors used for the Lockheed Martin contract, Air Force negotiators used DCAA's audit results to assist them in negotiating lower prices for the prime contracts; (9) Lockheed Martin and Northrop Grumman employed safeguard techniques required by U.S. procurement regulations to evaluate and negotiate subcontract and material prices for the prime contracts, and Air Force negotiators accepted the proposed and negotiated subcontract prices as fair and reasonable; (10) there are indications that material in the two prime contracts may be overpriced by as much as $947,000; (11) as for the two subcontracts selected by the European countries' Supreme Audit Institutions for review, Lockheed Martin awarded the Hazeltine subcontract competitively and the Honeywell subcontract noncompetitively; (12) in negotiating the price of the Honeywell subcontract, Lockheed Martin used rates and factors recommended by the cognizant U.S. government contract administration activity and employed the required safeguard techniques; and (13) the Air Force accepted the prices of these two subcontracts as fair and reasonable.