The Army, Navy, and Defense Logistics Agency approach to complying with Department of Defense requirements was to develop economic models to determine the maximum amount of inactive inventory they could retain. The Air Force did not develop an economic retention model; rather it employed a model based on historical usage patterns. Most recently, all the components lowered their maximum levels (referred to as ceilings) for items in economic retention during the 1990s to help them meet inventory reduction targets. The Department requires that an economic model calculating whether to retain an inventory item or dispose of it should compare the cost of retention with the cost of disposal and select the option with the least cost. As the amount of inactive stock increases, the cost of retention increases (more items cost more to hold) and the cost of disposal decreases (with greater amounts of an item on hand, the likelihood of having to repurchase it becomes less). Equilibrium is reached when the additional cost of retention equals that of disposal. This equilibrium level of inventory is the economic retention level—the largest retention amount of an inactive item that can be justified by economic analysis. Any amount of inventory over this level would become eligible for retention on a contingency basis or disposal. Management of the Department’s secondary inventory is a complex process, and effectively implementing systemwide improved management approaches has been a long-standing challenge for the Department.However, following the end of the Cold War, the Department recognized that it had unnecessarily high inventories as a result of major reductions in its force structure, and it directed the components to take action to lower inventory levels, including economic retention inventory. In response to this directive, during 1994, the Army, Navy, and Defense Logistics Agency chose to lower economic retention inventory levels by placing a preset maximum retention level that generally fell below the levels calculated by the models. The Air Force lowered its maximum level in 1996. The Department reported its economic retention inventory fell from about $13.8 billion to about $9.4 billion (about 32 percent) between fiscal year 1991 and 1999 (see fig. 1) and by 40 percent when adjusted for inflation. The latter part of this period covers the years when lower ceilings were put in place by the services and Defense Logistics Agency. Although all three services reported reductions in economic retention inventory levels during this time, the changes were uneven. The Air Force reported the smallest decrease in economic retention inventory—from about $5.1 billion to about $4.5 billion (about 12 percent). In contrast, the Army reported a decrease from about $1.3 billion to about $600 million (about 54 percent) and the Navy from about $5.6 billion to about $1.6 billion (over 71 percent). On the other hand, the Defense Logistics Agency reported an increase in economic retention inventory from about $1.8 billion to about $2.7 billion (about 50 percent) as a result of a decision to consolidate management responsibility for all consumable items within the Agency. According to Department data, if it had not required the services to transfer management of large quantities of inventory to the Defense Logistics Agency during the 1990s, the Defense Logistics Agency inventory would have decreased by over a billion dollars. (See app. I for more details on how the composition of secondary and retention inventory changed between fiscal year 1991 and 1999.) It is also important to note that, in response to a congressional mandate, the Department is conducting an independent study of secondary inventory and parts shortages as required by section 362 of the National Defense Authorization Act for Fiscal Year 2000. As described in the authorization act, the independent study is to include analyses of the appropriate levels and use of secondary inventories, alternative methods for disposing of excess inventory, and the application of private sector cost calculation models in determining the cost of secondary inventory storage. According to the Department, the study is scheduled for completion by the end of August 2001. The services and Defense Logistics Agency do not have sound analytic support for their approaches for determining whether they are holding the correct amount of items in economic retention inventory. While components (with the exception of the Air Force) developed individual economic models designed to place inactive inventory in economic retention status as early as 1969, they have not used them since 1994. Instead, components lowered maximum levels of inventory that could be held (referred to as ceilings) to make economic retention determinations that would help achieve agency inventory reduction goals. Agency information indicates that this approach has helped to reduce inventory levels. However, the components have not annually reviewed the analyses used to support their economic retention decisions, as required by the Department, and therefore have no assurance that the inventories held in economic retention status are appropriate. Although the components were not using their economic retention models to manage inventory levels, we did generally review the models. We noted that factors and assumptions within the models differed and were not current without explanation for the differences. Given the differences we found in these models, such as varied and outdated cost factors and assumptions and the lack of support for these factors and assumptions, it is uncertain whether they determine an accurate retention level. A methodology for determining how many items are to be kept in economic retention status, which the Department of Defense requires, should compare the costs of retention to the costs of disposal of an inventory item. The Army, Navy, and Defense Logistics Agency developed models designed for making economic decisions that consider the costs of retention and the costs of disposal. The Air Force does not compare retention and disposal costs in determining economic retention inventories. Instead, the Air Force employs historical usage levels to determine economic retention levels. The components developed their models in different ways and use different factors and assumptions in their models without detailed documentation. The amount of inventory to hold in economic retention varies by model depending on the factors and assumptions in the models. The economic retention models of the three components generally meet the Department’s requirements to compare retention costs to disposal costs, but the factors and assumptions in them vary across the components. For example, the Army and Navy use a factor of obsolescence and the Defense Logistics Agency does not. In addition, the values for similar factors used in economic retention models varied among components. For example, the Army’s value for loss rates (loss through theft or decay) is 1 percent, the Navy’s value is 4 percent, and the Defense Logistics Agency does not use a loss rate. Furthermore, the components have not appropriately updated their model assumptions. For example, prescribed discount rates, a key assumption in all economic retention models, vary across components’ models. The Navy uses a 10-percent discount rate and the Army and the Defense Logistics Agency use a 7-percent rate for computing net present values. Neither value matches discount rates recommended by the Office of Management and Budget for a cost-effectiveness analysis, which is the decision to retain or dispose of inventory. The rates are also inconsistent with our guidance on discount rates. For example, for the year 2000, the Office of Management and Budget discount rate for a cost-effectiveness analysis was 4.2 percent for a 30-year analysis; the rate was 2.9 percent in 1999. Further information about component economic models can be found in appendix II of this report. The use of a maximum level to manage economic retention stocks (commonly called ceilings by components) makes the Department vulnerable to retaining items when it is uneconomical to retain them or disposing of items that are economical to keep. The components judgmentally developed their ceilings for economic retention inventory, which differ and have yielded lower levels of economic retention inventory than the levels calculated by the economic retention models. During 1994-96, the components established different ceilings for items in economic retention. A ceiling imposes an upper constraint of years of demand—the quantity needed on an annual basis to meet requirements— on how much inactive inventory can be retained. Prior to the 1990s, the components had set ceilings on retention inventory that varied but that generally exceeded higher levels determined by their economic retention models. While component ceilings varied in the span of years of demand, they also varied in the total years of inventory covered. The Army ceiling is applied to inventories above active inventory requirements. The Air Force, Navy, and Defense Logistics Agency ceilings apply to their entire inventory requirements, including active inventory. Table 1 summarizes the maximum levels used by each component during the 1990s. According to component officials the components now hold fewer items in economic retention status because the ceilings established in the 1990s replaced the levels calculated by economic retention models. The components’ more stringent ceilings result in smaller inventory level determinations than would be calculated with economic retention models. Figure 2 illustrates the level a model might calculate and how a more constrained ceiling would override it. For example, a component’s ceiling for economic retention stock is 6 years of demand above requirements. If the model computed an economic retention limit (e.g., 8 years of demand of 25 items a year—200 items) that exceeded the maximum level (e.g., 6 years of demand—150 items), the ceiling (150 items) would be selected as the retention level. The additional stock (50 items) would be moved to other inactive categories (contingency or reutilization status) or be disposed of. Components have not reviewed their economic retention models or the judgmentally established ceilings annually, although required to do so by the Department. The lack of the components’ reviews of their retention analyses, either their models or ceilings, raises further questions about the cost-effectiveness of either approach. The Department’s required annual reviews are to focus on improving analyses supporting retention decisions by accounting for potential upward or downward trends in demand and/or the uncertainties of predicting future long-term demand based on historical data and improved estimates of costs used in retention decision-making. All components have conducted studies of their economic retention analyses, and initiatives were undertaken to meet inventory reduction goals during the 1990s, such as constraining economic retention model determinations with ceilings.