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 We noted that premature ordering occurred because the Air Force used inaccurate and outdated information, bought higher quantities than justified, or did not follow regulations governing the process.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.