The military exchanges are nonappropriated fund activities that are established, controlled by, and operated for the benefit of DOD components. Their mission is to provide (1) authorized patrons with articles and services necessary for their health, comfort, and convenience and (2) DOD’s morale, welfare, and recreation (MWR) programs with a source of funding. In carrying out this dual mission, the exchanges operate retail stores, similar to department stores, and provide a host of other services and specialty stores, including furniture stores, florist shops, barber and beauty shops, optical shops, liquor stores, and fast-food restaurants. For fiscal year 1999, the exchange services had over $9 billion in sales. For the past several years, about 70 percent of the exchange services’ profits from sales were allocated to MWR activities and about 30 percent to new exchange facilities and related capital projects. Military exchange services’ food operations generated about $734 million in sales during fiscal year 1999, or about 8 percent of the exchanges’ total sales. The sales occurred at about 2,200 food outlets operated by three military exchanges—the Army and Air Force Exchange Service (AAFES), the Navy Exchange Service Command (NEXCOM), and the Marine Corps Community Services (MCCS). These outlets, located on military installations around the world, included name-brand, fast-food restaurants, in-house signature brand restaurants, and more generic food operations such as cafeterias and snack bars. As shown by figure 1, over 50 percent of the $734 million in sales came from name-brand, fast-food outlets. Modern name-brand, fast-food restaurants began to appear on military installations in the early 1980s. In 1984, the Burger King Corporation and AAFES signed a 20-year, master contract authorizing AAFES to construct and operate 185 Burger King restaurants around the world. Each Burger King restaurant has a separate contract consistent with the terms of the master contract. Also in 1984, NEXCOM awarded a 10-year, master contract to McDonald’s Corporation. This contract, which was recompeted and renewed in 1994, allowed McDonald’s to construct and operate restaurants at more than 40 locations around the world. Both Burger King and McDonald’s contracts will expire in 2004. Today, other national brands, such as Baskin Robbins, Kentucky Fried Chicken, Pizza Hut, Popeye’s Chicken & Biscuits, Subway, Taco Bell, and Wendy’s, can also be found on military installations. (See app. II for the number of facilities and sales totals for AAFES and NEXCOM fast-food operations.) Fast-food restaurants are generally categorized by their location, size, and/or physical characteristics. A free-standing restaurant is often referred to as a traditional or stand-alone restaurant—it is located in a separate, distinct building with signage and logos that clearly identify its brand. A restaurant located in a food court is often referred to as a non-traditional or in-line restaurant. Free-standing restaurants are usually larger in size and have higher sales volumes than those found in food courts. The Assistant Secretary of Defense (Force Management) is responsible for establishing uniform policies for armed services exchange operations. In that capacity, the Assistant Secretary issued a policy memorandum for name-brand, fast-food operations in January 1988. The policy memorandum, which responded to recommendations from the House Committee on Armed Services, was issued to control the proliferation of fast-food restaurants on military installations and avoid a “fast-food strip” effect, award business to American investors, and ensure that name-brand, fast-food prices on military installations in the United States were comparable to those in communities adjacent to the military installation. The memorandum stated that the policy would be strictly followed and any deviations had to be approved in writing by the Assistant Secretary. However, the memorandum provided no criteria for approving a deviation. In addition, the primary armed services regulations governing MWR activities and the exchange services give the secretaries of the military services a stake in prescribing and overseeing the activities that can operate on their facilities, including the method that will be used to operate fast-food restaurants. Our analysis of fiscal year 1998 and 1999 financial data showed that the indirect method of operating name-brand, hamburger restaurants provided greater profitability than the direct method. This was true regardless of whether the restaurants were grouped and analyzed by sales volume, restaurant type (stand-alone or part of a food court), or location (continental United States or overseas). We also projected that if new name-brand, hamburger restaurants were to be built, the indirect method would result in a higher return on investment over a 20-year period. In conducting our analyses, we found that the exchange services had appropriately considered the various types of costs of their fast-food operations, except for overhead. We included overhead costs and the cost of capital in our analyses. For fiscal years 1998 and 1999, NEXCOM’s profits on 64 indirectly operated hamburger restaurants were about 11.5 percent and 11.4 percent, respectively, when measured as a percentage of total sales. Over the same period, AAFES’ profits on 164 and 171 directly operated hamburger restaurants were 7.8 and 5.5 percent, respectively. Table 1 provides the results of our analysis. Although the table does not show major differences in results between fiscal years 1998 and 1999, we have several observations about the profitability of the two alternatives. For servicemember morale purposes, AAFES operates a number of unprofitable Burger King restaurants in remote locations and overseas. In fiscal year 1999, for example, 56 of its 171 Burger King restaurants lost a combined $2.7 million. Eliminating these 56 restaurants from our analysis showed that the remaining 115 restaurants had profits of 9.2 percent of restaurant sales—this compares more favorably with NEXCOM’s 11.4 percent for that year. AAFES’ overhead rates (4.9 percent and 5.1 percent of sales) were significantly higher than NEXCOM’s (0.5 percent and 0.6 percent of sales) because of the different operating method. AAFES’ overhead rates captured the numerous support activities needed to manage the large infrastructure, distribution network, and personnel associated with the exchange’s operations. NEXCOM, on the other hand, had only a small number of support personnel to oversee its contracts with McDonald’s. NEXCOM’s revenues under the indirect method were derived from one-time signing bonuses, minimum guarantees, and annual licensing fees as well as commissions on restaurant sales. Signing bonuses and licensing fees accounted for approximately 25 percent of the revenues. Neither AAFES nor NEXCOM had established overhead rates for its restaurant operations. Therefore, we used the AAFES exchangewide rates, which are the rates AAFES applied to its overall operations for each of the 2 fiscal years. In response to our review, NEXCOM computed overhead rates that showed its limited support costs for overseeing its food service contracts. AAFES applied a 10-percent cost of capital to its restaurant operations, which, when measured as a percentage of sales, was 2.9 and 3.0 percent, respectively, for fiscal years 1998 and 1999. Because NEXCOM relies on McDonald’s and its licensed operators to build and periodically renovate the restaurant facilities, it had no capital costs. AAFES’ restaurant sales decreased about 4 percent between fiscal year 1998 and 1999 while its operating costs, as a percentage of sales, increased about 2 percent. These changes did not appear to be related to the method used to operate the restaurants. Both AAFES and NEXCOM rely on the military services for certain real property maintenance activities, particularly for repairs to the exterior of the restaurant building and the surrounding property. The exchanges, however, did not show these costs, and they were not readily available from the military services. In addition, both exchanges received similar support, which would tend to mitigate the cost impact on relative profitability. Therefore, we did not include them in our analysis. As part of our analysis, we evaluated the profitability of both methods from several perspectives—by sales volume, restaurant type (free-standing or food court), and location (continental United States or overseas). Each analysis showed that the indirect method was more profitable. Profitability by Sales Volume: We arrayed AAFES’ directly operated and NEXCOM’s indirectly operated restaurants by annual sales volumes. As shown in table 2, the profitability of both types of restaurants improved as sales volumes increased. However, NEXCOM’s profits measured as a percentage of sales were higher than AAFES’ in all categories for both fiscal years. For some categories, such as sales over $500,000 but less than $1 million, they were more than twice as high. For example, in fiscal year 1998, AAFES’ restaurants had profits of 3.0 percent of sales while NEXCOM’s restaurants had profits of 6.6 percent of sales. AAFES’ profitability was negatively affected by a large number of smaller restaurants that lost money in fiscal years 1998 and 1999. In 1999, for example, 44 of its 97 restaurants with sales under $1 million lost money. As table 2 shows, AAFES’ restaurants with sales of $500,000 or less lost 3.1 percent of sales and 1.7 percent of sales for fiscal years 1998 and 1999, respectively. Profitability by Restaurant Type: Both AAFES and NEXCOM operate traditional or free-standing hamburger restaurants and smaller non-traditional or food court type restaurants. As shown in table 3, free-standing restaurants, which tend to have higher sales volumes, were more profitable than restaurants located in a food court. NEXCOM’s average profits, however, were higher in both fiscal years for each type of restaurant.