The Air Force depot maintenance activity group is part of the Air Force Working Capital Fund, a revolving fund that relies on sales revenue rather than direct congressional appropriations to finance its operations. DOD policy requires working capital fund activity groups to (1) establish sales prices that allow them to recover their expected costs from their customers and (2) operate on a break-even basis over time—that is, not make a profit nor incur a loss. DOD policy also requires the activity group to establish its sales prices prior to the start of each fiscal year and to apply these predetermined or “stabilized” prices to most orders received during the year—regardless of when the work is actually accomplished or what costs are actually incurred. For the depot maintenance activity group, DOD policy also requires the group to recoup unbudgeted losses of $10 million or more in the year in which they occurred. In the case of losses that occur in the fourth quarter, the losses are to be recovered in the first quarter of the next fiscal year. Developing accurate prices is challenging since the process to determine the prices begins about 2 years in advance of when the work is actually received and performed. In essence, the activity group’s budget development has to coincide with the development of its customers’ budgets so that they both use the same set of assumptions. To develop prices, the activity group estimates (1) labor, material, overhead, and other costs based on anticipated demand for work as projected by customers, (2) total direct labor hours for each type of work performed, such as aircraft, engines, and repairable inventory items, (3) the workforce’s productivity, and (4) savings due to productivity and other cost avoidance initiatives. In order for an activity group to operate on a break-even basis, it is extremely important that the activity group accurately estimate the work it will perform and the costs of performing the work. Higher-than-expected costs or lower-than-expected customer demand for goods and services can cause the activity group to incur losses. Conversely, lower-than-expected costs or higher-than-expected customer demand for goods and services can result in profits. With sales prices based on assumptions that are made as long as 2 years before the prices go into effect, some variance between expected and actual costs is inevitable. We have previously reported that DOD has had long-standing problems in preparing accurate working capital fund financial reports. The DOD Inspector General and/or the Air Force Audit Agency have not been able to express an opinion on the reliability of the working capital fund’s financial statements for fiscal years 1993 through 2003. The auditors reported that the financial information was unreliable and financial systems and processes, as well as associated internal control structures, were inadequate to produce reliable financial information. The Air Force recognized that the existing legacy depot maintenance accounting systems that were designed in the 1960s and 1970s did not produce usable, complete, reliable, timely, consistent, and auditable information. According to the Air Force, among other things, these systems (1) were not transaction driven, (2) did not capture costs at the task level, and (3) did not produce accurate financial statements. To help improve the depot maintenance activity group’s financial management operations, in January 1998, the Assistant Secretary of the Air Force for Financial Management approved the implementation of the Depot Maintenance Accounting and Production System—which includes an accounting system called the Defense Industrial Financial Management System (DIFMS) that originally belonged to the Navy—at the depots located at the air logistics centers. According to the Air Force, this system is designed to provide the accurate task-level cost data that are needed to support (1) financial analysis and cost management and (2) the development of prices that more accurately reflect the cost of providing goods and services to customers. The Air Force is in the process of implementing this system and plans to complete the implementation during fiscal year 2004. We identified five factors that accounted for about 95 percent of the sales price increase from $119.99 per direct labor hour in fiscal year 2000 to $237.84 per hour in fiscal year 2004. By far the most significant of these factors was material costs, which accounted for about 67 percent of the total increase. Air Force depot maintenance officials have yet to complete an effective and comprehensive analysis to determine the underlying causes of the material cost increases. Our analysis of the other four factors identified a variety of underlying causes, some of which were beyond the activity group’s control, such as rising health care costs and maintenance and modernization of equipment and facilities. However, our analysis of the two factors that involved surcharges determined that the carryover surcharge (based on anticipated losses on work carried over from the previous fiscal year) was probably too high for fiscal year 2004 and may have been unnecessary, while the fiscal year 2004 cash surcharge was unnecessary and should not have been added to the depot’s composite hourly sales price. Details on the five factors follow. Higher budgeted material costs accounted for about 67 percent of the total increase in the composite hourly sales price. Air Force depot maintenance officials provided anecdotal evidence to show that the higher material costs were caused at least partly by (1) the need to replace component parts more frequently because of both safety concerns and the aging of aircraft and engines and (2) increases in the prices that the depot maintenance activity group must pay its suppliers for component parts. However, because Air Force depot maintenance officials have not completed a comprehensive analysis to determine the underlying causes of why their material costs have increased, they cannot quantify the impact of the identified causes and are unsure if they have identified all of the major causes. Higher budgeted labor costs accounted for about 10 percent of the increase in the activity group’s composite hourly sales price. Our analysis showed that the higher labor costs were caused largely by factors beyond the activity group’s control, such as annual salary increases for federal employees and rising health care costs. Higher non-labor, non-material overhead costs, which the Air Force calls business operations costs, accounted for about 8 percent of the total increase. Our analysis showed that the primary causes were (1) costs related to the implementation of a new accounting system and (2) the fact that the fiscal year 2004 budget provided significant increases in several areas where expenditures had been constrained for several years, such as the maintenance and modernization of equipment and facilities. An increase in the surcharge included in the composite hourly sales prices to recoup anticipated losses on work carried over from the previous fiscal year (carryover surcharge) accounted for about 7 percent of the total increase in the sales price. Our analysis showed that the fiscal year 2004 carryover surcharge was probably too high and may have been unnecessary. An increase in the surcharge included in the composite hourly sales prices to generate additional cash (cash surcharge) accounted for about 3 percent of the total increase in the sales price. Our analysis also showed that the fiscal year 2004 cash surcharge was unnecessary because the Air Force Working Capital Fund’s $2.5 billion cash balance as of January 31, 2004, was already more than $1.3 billion higher than the maximum level allowed by DOD policy. Either the Office of the Secretary of Defense or the Congress could use this unneeded cash to satisfy other requirements. Table 1 shows the impact these factors had on the group’s composite sales price. As table 1 also shows, about 5 percent of the price increase was due to factors we either did not identify or could not quantify. As shown in table 1, although many factors contributed to the increase that occurred in the composite hourly sales price for fiscal years 2000 through 2004, higher budgeted material costs were, by far, the most significant. Further, our analysis showed that higher budgeted material costs had an even greater impact on some workloads. For example, the sales price for the repair of E-3 airborne warning and control system (AWACS) aircraft increased from $119.69 per hour in fiscal year 2000 to $330.06 per hour in fiscal year 2004, about 176 percent, and the price for the repair of F108-100 engines used in the KC-135 aircraft increased from $183,240 per engine in fiscal year 2000 to $1,214,124 per engine in fiscal year 2004, about 563 percent. Figure 1 shows the activity group’s budgeted and reported actual material costs per direct labor hour of work accomplished (material expense rate) for fiscal years 2000 through 2004. While Air Force depot maintenance officials can provide anecdotal evidence on why the activity group’s overall material costs have increased, they have yet to complete an effective and comprehensive analysis to determine why material costs have increased. Air Force depot maintenance officials believe the activity group’s higher material costs can be attributed, to a large extent, to increased material usage that has been caused by (1) the aging of the Air Force’s aircraft and engine inventory and (2) safety concerns. Further, they can provide anecdotal evidence to support their views. For example: Material costs related to the F-15 aircraft, which is more than 30 years old, have increased significantly over the past several years, in part, due to its age. For example, the Air Force is in the process of replacing the aircraft’s structural surfaces with a material—called gridlock—that is more expensive than the material that was used in the past to make structural repairs. According to Air Force officials at the air logistics center making the repairs, the new material is not prone to the problems that plagued the old material. As a result, the new material should allow for longer intervals between structural surface repairs and reduce structural repair costs in the future.