The Air Force supply management activity group (SMAG) helps to maintain combat readiness and sustainability by supplying the Air Force with items necessary to support troops, weapon systems, aircraft, communications systems, and other military equipment. In doing so, SMAG is responsible for about two million items, ranging from weapon system spare parts to fuels, food, medical and dental supplies and equipment, and uniforms. SMAG is the largest supply management activity in Defense—it reported $12 billion in revenue and $24.5 billion in inventory for fiscal year 1997. SMAG operations are financed as part of the Air Force Working Capital Fund, which was formerly a part of the Defense Business Operations Fund. In December 1996, the Under Secretary of Defense (Comptroller) dissolved the Defense Business Operations Fund and created four working capital funds to clearly establish the military services’ and DOD components’ responsibilities for managing the functional and financial aspects of their respective activity groups. The funds are to operate by charging customers the full costs of goods and services provided to them as currently defined in the Department of Defense’s (DOD) Financial Management Regulation, Volume 11B, Reimbursable Operations, Policy and Procedures—Defense Business Operations Fund. The primary goal of the current working capital fund financial structure is to focus the attention of all levels of management on the full costs of carrying out certain critical DOD business operations and the management of those costs. Unlike a private sector enterprise which has a profit motive, the four working capital funds are to operate on a break-even basis over time by recovering the full costs incurred in conducting the business operations. Accomplishing this requires DOD managers to become more conscious of operating costs and make fundamental improvements in how DOD conducts business since customers have a defined amount of funds to pay for goods and services. It is critical for the working capital funds to operate efficiently since every dollar spent inefficiently is one less dollar available for other defense spending priorities. As figure 1.1 illustrates, SMAG receives orders from customers to purchase inventory items. Customers use appropriated funds, primarily Operation and Maintenance appropriations, to finance these orders. SMAG provides the inventory items to customers and bills customers on the basis of predetermined prices—commonly referred to as standard prices, which generally are to be in force throughout the entire fiscal year. SMAG uses payments from customers to replenish the inventory sold to customers by (1) buying new inventory items or (2) ordering repair services of existing inventory from industry and DOD depot maintenance activities as well as to cover operating costs. SMAG procures critical material and makes repair parts available to its customers through five inventory control points: Ogden Air Logistics Center (ALC), Ogden, Utah; Oklahoma City ALC, Oklahoma City, Oklahoma; Sacramento ALC, Sacramento, California; San Antonio ALC, San Antonio, Texas; and Warner Robins ALC, Warner Robins, Georgia. The five ALCs report to the Air Force Materiel Command (AFMC), located at Dayton, Ohio. SMAG’s operations are divided into two main categories: wholesale and retail. Wholesale operations encompass about 200,000 types of inventory items (generally weapon system related) for which the Air Force is the inventory control point. SMAG procures, manages, and sets the prices that customers will pay for these wholesale items. The wholesale prices include SMAG’s operational support cost, such as civilian salaries and accounting costs. SMAG adds a surcharge to the acquisition cost or repair cost of the individual inventory items to recover its operating costs. SMAG retail inventory operations encompass items that are managed by the other services, Defense agencies, or government agencies. These non-Air Force entities are the inventory control points for these items and, therefore, set the prices for these items. The retail portion of SMAG purchases these items from the non-Air Force entities and then resells them to customers. Since fiscal year 1991, the composition of the inventory items and costs managed by SMAG has significantly changed, making it more complicated for SMAG to manage, budget, and account for inventory. Prior to fiscal year 1991, SMAG consisted of the following six divisions: (1) systems support, (2) general support, (3) fuels, (4) medical/dental, (5) commissary, and (6) the Air Force Academy Cadet Store. The systems support division—the only wholesale division—procured consumable items (items that are replaced rather than repaired) for aircraft, missiles, and their major components. Beginning in fiscal year 1991, the Air Force added two new wholesale divisions to its stock fund operations: the reparable support and cost of operations divisions. The reparable support division procures depot level repairables and pays for the repair of these repairable inventory items. Managing repairable items was a new function for SMAG, and it complicated the budgeting and accounting for inventory items since SMAG did not have any experience in setting prices to recover the cost to repair items. The cost of operations division included the overhead costs for the five inventory control points of the stock fund which also complicated matters for the stock fund since these costs were not previously captured and included in the prices charged customers. The effect of adding the repairable support and cost of operations divisions to the stock fund is significant. For example, in fiscal year 1997, the Air Force reported wholesale division sales of about $6.8 billion of which only a reported $500 million pertained to the systems support division—the only wholesale division that existed prior to fiscal year 1991. Three other changes also impacted SMAG’s operations. In fiscal year 1992, the commissary division was transferred from SMAG to the Defense Commissary Agency. The Air Force budgets show that the commissary division had estimated sales of $2.6 billion to $2.8 billion per year in the early 1990s. About 475,000 consumable items were transferred from the system support division to the Defense Logistics Agency from fiscal year 1992 through 1997. The transfer of these items significantly reduced the number of items managed by the systems support division to about 125,000 items. On October 1, 1997, the Air Force consolidated SMAG’s three wholesale divisions into one wholesale division called the Materiel Support Division. The Air Force created the Materiel Support Division to provide better cost visibility. Now, the estimated costs associated with each ALC are included in the prices of inventory items they manage. Previously, these costs were spread across the board to all inventory items. The objectives of our review were to evaluate the (1) accuracy and consistency of SMAG’s accounting and budgetary reports, (2) SMAG’s price-setting process, and (3) Air Force Working Capital Fund’s cash management practices, including the practice of advance billing customers. To evaluate the accuracy and consistency of SMAG’s accounting and budgetary reports, we (1) obtained and analyzed the Defense Working Capital Fund Accounting Report (1307), the Air Force Defense Business Operations Fund Chief Financial Officer Annual Financial Statement, and the Air Force’s Working Capital Fund budget justification report for fiscal years 1992 through 1996, (2) interviewed Air Force and Defense Finance and Accounting Service (DFAS) officials to determine why reports covering the same period provided widely different results, and (3) analyzed the DOD Working Capital Fund report, dated September 1997, that was prepared in response to the National Defense Authorization Act for Fiscal Year 1997, to determine the actions DOD is planning to improve the accuracy of the working capital fund’s accounting report. We also met with DOD Inspector General and Air Force Audit Agency officials to discuss the accuracy of SMAG’s financial reports. The quantitative financial information used in this report on SMAG’s financial operations was produced from DOD’s systems—which have long been reported to generate unreliable data. We did not independently verify this information. The DOD Inspector General has cited system deficiencies and internal control weaknesses as major obstacles to the presentation of financial statements that would fairly present the Defense Business Operations Fund financial position for fiscal years 1993 through 1996. To evaluate SMAG’s price setting-process, we (1) obtained and analyzed the budget documents used in setting prices, (2) interviewed Air Force comptroller and program officials at Headquarters and AFMC to discuss the rationale for the various factors, including cost reduction goals, used to develop SMAG’s prices charged customers, (3) analyzed documents on the new price-setting procedures and interviewed Air Force officials to determine if the Air Force encountered problems in implementing the new procedures, and (4) analyzed budget documents concerning prices and interviewed Air Force officials to determine why the Air Force changed the fiscal years 1997 and 1998 prices once they were implemented. To evaluate the Air Force’s Working Capital Fund’s cash management practices, including its practice of advance billing customers, we (1) collected and analyzed financial information related to the cash balances, advance billings, collections, disbursements, accounts receivable, and accounts payable from fiscal year 1992 through fiscal year 1997, (2) obtained and analyzed DOD and Air Force guidance on managing cash, and (3) interviewed officials in the Office of the Under Secretary of Defense (Comptroller), Air Force Headquarters, and AFMC concerning the cash management practices and the Air Force’s continual need to advance bill customers to alleviate the cash shortage problem. We also analyzed the DOD Working Capital Fund report, dated September 1997, that was prepared in response to the National Defense Authorization Act for Fiscal Year 1997, to determine the actions DOD is planning to improve the working capital fund’s cash management practices. We did not independently verify the reported cash information.