DOD inventory control points are responsible for managing insurance items. We performed our review at the Aviation Supply Office (ASO), one of two Navy inventory control points, and the Defense Industrial Supply Center (DISC), one of six DLA inventory control points. As of March 1994, ASO managed insurance inventories valued at $193 million and, as of April 1994, DISC managed insurance inventories valued at $3 million. Spare parts and other supplies normally are designated as insurance items during the initial provisioning process. Initial provisioning is designed to provide parts until there is a requisitioning history from which relatively accurate forecasts of future demands can be made. Typically, these parts support a weapon system during the first 2 years of operation. At ASO, contractors or manufacturers recommend which parts should be stocked for insurance purposes, ASO reviews these recommendations, and the Naval Air Systems Command approves the recommendations if it agrees with the contractor and ASO. DISC classifies items on the basis of submissions by the using military service during the initial provisioning process. We analyzed ASO and DISC records to identify insurance items and determine if they were properly classified. We found that most of the items were not mission essential and, therefore, should not have been classified as insurance items. Table 1 summarizes the results of our analysis. Because only a small percentage of the insurance items were fully justified in the inventory control point records, we asked item managers to verify the classification of the insurance items. We randomly sampled 329 ASO items and 110 DISC items and sent questionnaires to item managers asking them to validate the records. According to the ASO item managers surveyed, 51 percent of the items were not mission essential. Table 2 summarizes the sample results. We did not make a similar analysis for DISC because none of the item managers had responded to the questionnaire at the time our fieldwork was completed. Significant numbers of nonessential parts and supplies continue to be stocked as insurance items because ASO and DISC do not have the internal controls to periodically review insurance items to identify those that are unneeded because they do not meet essentiality criteria. As noted in tables 1 and 2, only 10.5 percent of ASO’s insurance items were mission essential according to ASO records and only 22 percent were mission essential according to item manager responses to our questionnaire. At DISC, 42.3 percent were mission essential according to its records. ASO assigns mission essentiality codes on the basis of reports from end users on how the failure of a part affects mission capability. These codes range from one where item failure results in minor mission impact to one where item failure results in loss of a primary mission capability. DISC assigns essentiality codes, called weapon system indicator codes, on the basis of data provided by the using military service. Neither ASO nor DISC systematically reviews insurance items to validate the essentiality codes. ASO does require an annual review to ensure that the data elements used to prevent automatic purchases of insurance items are correctly loaded in the computer. However, this review does not verify that insurance items are mission essential. DISC does not require a review of insurance item essentiality. The absence of essentiality reviews contributed significantly to the low percentage of mission essential items identified in our review. In addition to the 22 percent ASO item managers said were mission essential, they indicated that 51 percent of the insurance items were not mission essential and that they either could not or did not determine essentiality for the remaining 27 percent. The following examples illustrate the error conditions identified. ASO stocks three skin assembly units used on the AV-8B aircraft as insurance items. These units, which are valued at a total of $158,927, have a nonessential coding in ASO’s records. In responding to our questionnaire, the item manager agreed with the coding in the record and indicated that the units were not mission essential. These assemblies have been in the Navy supply system since the weapon system was provisioned in 1986. In another case, ASO stocks 12 manual control levers used on the F/A-18 aircraft as insurance items. These levers, which are valued at a total of $997,020, have been in the supply system since 1983. Again, the item manager indicated that the lever, although categorized as an insurance item in the records, was not mission essential. Although DOD Material Management Regulation 4140.1-R, dated January 1993, states that only one replacement unit of an item may be stocked for insurance purposes, we found that ASO and DISC stocked many of the insurance items in quantities greater than one unit. This condition was true for both mission essential items and nonessential items. At ASO, 4,997 insurance items, valued at $126 million, or 50 percent, of the 9,937 insurance items were stocked in quantities greater than one unit. Of the 1,042 mission essential items included in these totals, 510 items had excessive quantities valued at $49 million. At DISC, 1,602, or 48 percent, of the 3,335 insurance items were stocked in quantities greater than one unit, including 784 of 1,410 mission essential items. The reasons for the excessive quantities are similar to the reasons that nonessential items are stocked as insurance items. That is, much of the excessive buildup occurred during the initial provisioning process. DOD downsizing and weapon system obsolescence and retirement also contributed to the stock buildup. However, neither ASO nor DISC has established the internal controls to periodically review insurance items to ensure that quantities are kept at the allowable stock level of one unit. An additional factor contributing to the excessive quantities is the inventory control points’ stock retention policies. ASO and DISC have computer programs to identify and recommend excess stock for disposal. ASO programs search for stocks in excess of retention levels and are run for all stocked items, not just insurance items. However, irrespective of retention levels, the programs will not recommend disposal action on quantities that fall below a floor of five units at ASO. The DISC programs identify disposal prospects on a selective basis and have not been run for insurance items. The computer programs have not been effective in reducing excess insurance stocks at ASO for two major reasons. First, contrary to DOD regulations, ASO has established retention levels for many insurance items that exceed the allowed stockage quantity of one unit. Second, the requirement that any disposal recommendation leave an on-hand quantity of five units precludes reducing the stockage level to one unit. As a result, only 330 of the 4,997 insurance items that we found to be overstocked were identified as such by ASO’s computer program. The following examples illustrate the overstockage conditions identified. ASO stocks 20 aircraft seat structures used on the A-7 aircraft as insurance items. These structures, which are valued at a total of $2,559,586, have been in the supply system since 1979. In responding to our questionnaire, the item manager indicated that 14 of these units were removed from aircraft as a result of design changes and were unserviceable. The remaining six units were serviceable but exceeded the allowed insurance stock level of one unit. In another case, ASO stocks two electrical equipment racks used on the E-2C aircraft as insurance items. These racks, which are valued at a total of $687,480, exceed the allowed insurance stock level of one unit but will not be reviewed for potential disposal because the quantity falls below ASO’s on-hand stockage floor of five units. The item manager agreed that the racks were in an excess position but would not recommend this item for disposal because of the on-hand stockage floor. In addition to unneeded procurement costs, DOD incurs large costs to manage and maintain excess inventories, particularly items with low demand or years of supply on hand. DOD expresses these holding costs as a percentage of the value of on-hand inventory. Holding costs include investment cost, or the cost of having funds tied up in inventory; storage costs; and obsolescence costs. The holding cost rate varies by inventory control point and averages 22 percent at ASO and 18 percent at DISC. In commenting on our draft report, DOD stated that the holding cost rates we used may be correct before a purchase decision is made, but once material is in inventory the risk of obsolescence is represented as a sunk cost and the opportunity to spend the funds on an alternative investment has been foregone. DOD also stated that the holding cost rates that should have been applied for material in stock is at least an order of magnitude less than the rates used in the report. DOD did not give an alternative percentage or amount and DOD’s accounting systems are not designed to capture actual holding costs. In commenting on another report (GAO/NSIAD-94-110, June 29, 1994), DOD agreed that unnecessarily large inventories increase holding costs and acknowledged that holding cost rates that only cover storage costs may not be appropriate. For example, reducing inventories by quantities sufficient to close warehouses would result in savings that exceed storage costs. While it is difficult to precisely determine the costs to manage and maintain nonessential and excessive insurance stocks, our review and DOD’s comments indicate that these costs would be millions of dollars a year. We recommend that the Secretary of Defense direct the Secretary of the Navy and the Director, Defense Logistics Agency, to (1) periodically review insurance items to ensure that they are mission essential and stocked in allowable quantities and (2) dispose of existing nonessential and excess insurance stock. We further recommend that the Secretary of the Navy direct the Commanding Officer, ASO, to set the retention level for insurance items at one unit and change the disposal computer program so that the on-hand stockage floor for these items also is one unit.