Foreign military sales are made on a case by case basis. The cases are initiated by a foreign country sending a letter of request to DOD asking for various information, such as precise price data. After the country obtains and reviews this information and decides that it wants to do business with the U.S. government, DOD prepares a Letter of Offer and Acceptance (LOA) stating the terms of the sale for the goods and services being provided. If accepted by the country, the LOA becomes the formal sales agreement by which the U.S. government contracts with the country to sell it defense articles or services. Once the LOA is accepted, the foreign country is generally required to pay, in advance, amounts necessary to cover costs associated with the sales agreement. DOD then uses these funds, held in trust by the Department of the Treasury, to pay private contractors and to reimburse DOD activities for the cost of executing and administering the FMS agreement. As payments are made, the military services report detailed disbursing and accounting data to a central activity—the Defense Finance and Accounting Service, Denver Center—which maintains the records of each country’s trust fund balance and issues quarterly statements to foreign customers summarizing amounts charged to their cases. In October 1991, DOD established DBOF, which consolidated into one revolving fund, nine existing industrial and stock funds that had operated within DOD for about 45 years, as well as the Defense Finance and Accounting Service, Defense Industrial Plant Equipment Service, Defense Commissary Agency, Defense Reutilization and Marketing Service, and Defense Technical Information Service. In establishing DBOF, one of DOD’s primary goals was to identify the total cost of operations and to highlight the cost implications of management decisions. DOD’s Financial Management Regulation 7000.14-R, Volumes 11B and 15 prescribe the financial management requirements, systems, and functions that WCF activities are to follow when establishing prices and billing FMS customers.Generally, billings to these customers shall reimburse the WCF for the full cost incurred by the U.S. government for providing the goods or services. According to the regulation, full cost is determined by the application of the stabilized rates or unit prices which are set to achieve a break-even operating result in the budget year—that is, neither to make a profit nor incur a loss. Since the concept of DBOF was first put forth in February 1991, we have monitored and evaluated its implementation and operation. We have issued numerous reports discussing various problems with fragmented cost accounting systems and inaccurate financial reporting. More specifically, one problem we found was that not all costs were being captured in the price-setting process, thus, resulting in less than full cost recovery. However, in our May 1997 testimony before the Subcommittee on Defense, Senate Committee on Appropriations, we noted that DOD has progressed significantly in identifying the cost of doing business and including those costs in the prices DBOF charged its customers. To determine regulatory requirements for billing FMS customers using stabilized rates and prices, we obtained and analyzed laws, policies, procedures, regulations, and guidance from DOD, Army, Navy, and Air Force officials. During our visits to DOD locations, we gathered and analyzed budget and accounting reports to identify cost elements in the prices of goods and services sold to FMS customers. We compared these cost elements with other cost data in various databases and met with responsible agency officials to discuss and clarify any differences in (1) cost elements used for FMS and DOD customers and (2) the amounts charged. To determine the amount of civilian pension and postretirement health benefit costs that should have been collected from FMS customers by WCF supply activities, we obtained and analyzed financial reports that showed sales and expense data for Army, Navy, Air Force, and Defense Logistics Agency supply activities for fiscal years 1992 through 1996. Because these activities generally did not maintain data to identify how much time personnel spent providing services to FMS customers, we estimated the amounts of civilian pension and postretirement health benefit costs related to FMS using certain assumptions. To do this, we first calculated the dollar value of FMS sales as a percentage of total dollar sales for each of the activities for each fiscal year. For example, if a supply activity showed that its annual sales were $1 billion of which $100 million were to FMS customers, we calculated sales to FMS customers to be 10 percent ($100 million divided by $1 billion). To calculate the pension benefit costs, we multiplied the percent of each year’s FMS sales by the total amount of civilian personnel salaries reported as paid during the year to determine a pro rata dollar amount for FMS civilian personnel salaries. Finally, to determine the estimated amount of civilian pension benefit costs to be collected from FMS customers, we multiplied the pro rata dollar amount of FMS personnel salaries times the civilian pension benefit cost factor of 14.7 percent for each activity for fiscal years 1992 through 1996. According to the Office of Management and Budget (OMB) and DOD officials, the 14.7 percent rate represents the “unfunded” portion of the pension benefit cost which is derived by subtracting DOD’s 7 percent contribution to the pension costs of its employees (21.7 percent less 7 percent). The 7 percent DOD contribution is already included in the stabilized rate as a funded fringe benefit cost. To determine the amount of civilian postretirement health benefit cost, we multiplied the percentage of FMS sales to total sales times the civilian end strength for each supply activity for fiscal years 1992 through 1996. For example, if the pro rata amount of FMS sales to total sales was 10 percent for fiscal year 1996 and an activity reported civilian end strength at 5,000 employees for the same period, our calculated FMS civilian end strength would be 500 full time employees involved with FMS activities (10 percent times 5,000 employees). Using these numbers, we multiplied the pro rata amount by $2,166 which was the Office of Personnel Management (OPM) calculated amount of average postretirement health benefit cost per employee for fiscal year 1996. To determine the postretirement health benefit cost per employee for fiscal year 1995 and earlier, we contacted officials in OPM’s Office of Actuaries, including the Deputy Director of the Office of Actuaries. According to the OPM officials, prior to fiscal year 1996, OPM had not published any formal amounts for agencies to use in calculating pension or postretirement health benefit costs. However, OPM officials told us that postretirement health benefit costs have increased by about 7 percent each fiscal year. Therefore, according to OPM officials, we could determine the fiscal year 1995 postretirement health benefit cost by dividing the fiscal year 1996 cost of $2,166 by 107 percent. Fiscal year 1994 could then be determined by dividing the fiscal year 1995 postretirement health benefit cost by 107 percent and so on for each preceding fiscal year. The OPM officials generally agreed with our methodologies for calculating estimated pension and postretirement health benefit costs. We did not calculate pension benefit cost for nonsupply activities because the nonsupply activities were generally including these costs in their prices for FMS customers. They did not, however, include the postretirement health benefit cost in their prices. Since they were recovering the largest segment of the retirement benefit cost, we did not attempt to estimate undercharges for postretirement health benefit cost for the nonsupply activities. To do so would have required us to analyze numerous detailed accounting and budget reports of over 100 additional WCF activities. Over the years, both we and the DOD Inspector General have reported that the DOD’s financial systems used to collect and report data are not capable of producing accurate and reliable information. Our estimates were based on financial information provided by DOD which we did not independently verify. We performed our work at the headquarters, Departments of the Army, Navy, Air Force; Defense Security Assistance Agency; and Office of the Under Secretary of Defense (Comptroller) in Washington, D.C. We also performed audit work at the Army Materiel Command, Alexandria, Virginia; Air Force Materiel Command, Wright Patterson Air Force Base, Dayton, Ohio; Naval Inventory Control Point, Mechanicsburg, Pennsylvania; Naval Air Warfare Center, Patuxent River, Maryland; Naval Surface Warfare Center, Indian Head, Maryland; Defense Logistics Agency, Fort Belvoir, Virginia; and Letterkenney Army Depot, Chambersburg, Pennsylvania. We conducted our review from November 1996 through July 1997 in accordance with generally accepted government auditing standards. We requested written comments on a draft of the report from the Secretary of Defense or his designee. The Acting Under Secretary of Defense (Comptroller) provided written comments, which are discussed in the “Agency Comments” section and reprinted in appendix I. The concept of a stabilized rate is a viable method to use for pricing goods and services sold to FMS customers. If this rate is applied consistently and contains all known cost elements, it should recover the full cost of operations over the long term. In analyzing the cost elements in the stabilized rate, we identified additional elements—pension and postretirement health benefit costs which are part of the civilian labor costs—that should have been included in developing the stabilized rate and charged to FMS customers. Omission of these costs resulted in estimated underbillings of more than $40.5 million since fiscal year 1992. Present DOD policy requires the WCF activities to establish prices that allow them to recover from their customers the expected costs, including any prior years’ losses. WCF activities are to establish prices prior to the start of each fiscal year and apply these predetermined (stabilized or standard) prices to most orders and requisitions received during the year.