According to the Navy’s fiscal year 2003 budget, the Navy Working Capital Fund will earn about $20.8 billion in revenue during fiscal year 2003. The Navy Working Capital Fund consists of the following six major activity groups: depot maintenance, transportation, base support, information services, supply management, and research and development. The Navy estimates that the research and development activity group will earn about $7.7 billion during fiscal year 2003, the largest activity group in terms of the dollar amount of revenue earned. This activity group includes the following subactivity groups: (1) the Naval Surface Warfare Center, (2) the Naval Air Warfare Center, (3) the Naval Undersea Warfare Center, (4) the Naval Research Laboratory, and (5) the Space and Naval Warfare Systems Centers. The SPAWAR systems centers are the Navy’s full-spectrum research, development, test and evaluation, engineering, and fleet support centers for command, control, and communication systems and ocean surveillance and the integration of those systems. The systems centers (1) support the fleet in mission and capability by providing capable and ready command and control systems for the Navy and (2) provide the innovative scientific and technical expertise and facilities necessary to ensure that the Navy can develop, acquire, and maintain the warfare systems needed to meet requirements. The SPAWAR systems centers’ primary locations are in San Diego, California and Charleston, South Carolina. As part of the Navy Working Capital Fund, the SPAWAR systems centers rely on sales revenue rather than direct congressional appropriations to finance their operations. DOD policy requires working capital fund activity groups to (1) establish 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 groups to establish their sales prices prior to the start of each fiscal year and to apply these predetermined or “stabilized” prices to most orders received from customers during the year—regardless of when the work is actually accomplished or what costs are actually incurred. Customers use appropriated funds to finance the orders placed with the SPAWAR systems centers. When a systems center accepts the customer order, its own obligational authority is increased and the customer’s appropriation is obligated by the amount of the order. The working capital fund activity incurs obligations for costs, such as material and labor, to perform the work. In addition to receiving orders from customers to do work as part of the working capital fund, SPAWAR systems centers also award hundreds of millions of dollars in contracts with the private sector for work to be performed for the centers’ customers. These contracts and related work are not included in the working capital fund from a financial standpoint because the contractors directly bill the customers for work performed and the customers directly pay the contractors. DOD and the Navy refer to this process of awarding contracts for customers as direct cite orders, since the SPAWAR systems centers cite the customers’ appropriation(s) on the contracts. The customers’ funds are obligated when the systems centers award the contracts with contractors. Carryover is the dollar value of work that has been ordered and funded (obligated) by customers but not yet completed by working capital fund activities at the end of the fiscal year. Carryover consists of both the unfinished portion of work started but not yet completed, as well as requested work that has not yet commenced. To manage carryover, DOD converted the dollar amount of carryover to equivalent months of work. This was done to put the magnitude of the carryover in proper perspective. For example, if an activity group performs $100 million of work in a year and had $100 million in carryover at year-end, it would have 12 months of carryover. However, if another activity group performs $400 million of work in a year and had $100 million in carryover at year-end, this group would have 3 months of carryover. The congressional defense committees and DOD have acknowledged that some carryover is necessary at fiscal year-end if working capital funds are to operate efficiently and effectively. In 1996, DOD established a 3-month carryover standard for all the working capital fund activities except for the contract portion of the Air Force depot maintenance activity group. In May 2001, we reported that DOD did not have a basis for its carryover standard and recommended that DOD determine the appropriate carryover standard for the depot maintenance, ordnance, and research and development activity groups. Based on our recommendation, in December 2002, DOD revised its carryover policy for working capital fund activities. Under the revised method, DOD eliminated the 3-month standard, and the allowable amount of carryover is to be based on the overall disbursement rate of the customers’ appropriations financing the work. Too little carryover could result in some activity groups not having work to perform at the beginning of the fiscal year, resulting in the inefficient use of personnel. On the other hand, too much carryover could result in an activity group receiving funds from customers in one fiscal year but not performing the work until well into the next fiscal year or subsequent years. By minimizing the amount of the carryover, DOD can use its resources most effectively and minimize the “banking” of funds for work and programs to be performed in subsequent years. For fiscal years 1998 through 2002, SPAWAR systems centers’ budgeted gross carryover was significantly less than reported actual gross carryover, thereby providing decision makers, including the Office of the Under Secretary of Defense (Comptroller) and congressional defense committees, misleading carryover information. These decision makers use carryover information to determine whether the SPAWAR systems centers have too much carryover. If the systems centers have too much carryover, the decision makers may reduce the customers’ budgets and use these resources for other purposes. For example, during its review of the fiscal year 2003 budget, the Office of the Under Secretary of Defense (Comptroller) noted that the Navy research and development activities carryover had been steadily increasing from about $2.2 billion in fiscal year 1997 to about $3.4 billion in fiscal year 2003. Since a significant portion of the carryover was related to work that was to be contracted out, the Office of the Under Secretary of Defense (Comptroller) reduced the customer funding by $161.1 million because these efforts could be funded in fiscal year 2004 with no impact on performance. SPAWAR systems centers’ reported actual year-end gross carryover was substantially greater than their budgeted gross carryover. Table 1 shows that from fiscal year 1998 through fiscal year 2002 reported actual gross carryover exceeded budgeted gross carryover, and the difference has increased from about $153 million to about $286 million. The Navy’s budget requests consistently underestimated SPAWAR systems centers’ gross carryover, in part, because the Navy consistently underestimated the amount of orders to be received from customers by hundreds of millions of dollars. Table 2 shows that the amount of difference between budgeted and reported actual orders increased from about $352 million (39 percent) in fiscal year 1998 to about $1.1 billion (88 percent) in fiscal year 2002. Since orders received from customers are the major source of funds for SPAWAR and one of the key factors in determining the amount of carryover at fiscal year-end, it is critical that the Navy has accurate budget estimates on the amount of orders to be received from customers. However, for fiscal years 2000, 2001, and 2002 actual orders exceeded budgeted orders by at least 68 percent each year. The data in table 2 indicate that the SPAWAR systems centers’ customers have not accurately estimated the amount of orders they will place with the systems centers. Customers determine and justify their anticipated requirements for goods and services and the levels of performance they require from the systems centers to fulfill mission objectives. Our analysis of budget and accounting reports that provide information on customer orders shows that orders financed with three appropriations made up a large part of the differences in fiscal years 2000, 2001, and 2002. The appropriations used by customers to finance 49 percent to 67 percent of the differences for these 3 fiscal years were the Other Procurement, Navy appropriation; Research, Development, Test, and Evaluation, Defense appropriation; Research, Development, Test, and Evaluation, Navy appropriation. Officials from the Charleston and San Diego Systems Centers and SPAWAR headquarters stated, and our work found, that customers have historically understated their budget estimates on customer orders that are received by the SPAWAR working capital fund. They stated that the systems centers’ budgets for orders are based on what the customers tell them their requirements would be for a particular fiscal year. However, they also told us that customers are hesitant to make a full commitment to the estimated amount of work that will need to be performed. SPAWAR and Navy headquarters budget officials acknowledged that the SPAWAR systems centers’ budgets have consistently understated gross carryover and orders received from customers (claimants). They also stated that the dollar amount of orders that the systems centers receive from customers must match the dollar amount of orders that customers submit in their appropriated fund budgets. Customers only record in their budgets those orders that they will be sending directly to the systems centers. If a customer initially allocates budgeted funds to an activity not related to the working capital fund—which is a third party—and the third party places the order with a SPAWAR systems center, the customer’s budget reflects that these funds went to a third party. This results in the amount of budgeted orders that the systems centers receive from customers being understated.